Modern TMT managers challenge traditional skin-in-the-game incentives

From an investor's perspective, equity-based incentivisation generally requires the investor and management to agree a package that strikes the right balance between a number of factors.

There needs to be the carrot that, should the plan be delivered, management will share in what will hopefully be considerable upside for all. This generally comes with the stick that much – and sometimes all – of this upside would be lost if a manager were to leave prior to the investor's exit. If the manager invests or reinvests any substantial sum, this "skin in the game" can often be a decisive factor in preventing a desirable manager's head being turned by other opportunities.

Both the prevalence of fast-growing businesses in the technology, media and telecommunications (TMT) sector and successful VC exits have been the catalysts for an increase in the number of individuals who, often having made significant capital already, are prepared to challenge these longstanding principles.

If the terms offered [by PE owners] require an individual to remain in a business for three to five years on an exclusive basis to realise his or her returns, they may be less enthusiastic than the investor was expecting" – Jonny Bethell, Taylor Wessing

At a senior management level, there is an increasing group of people who – having displayed creativity, skill, business acumen and leadership in one business – would now like to have the opportunity to choose the nature and extent of their next role on a case-by-case basis.

The problem for private equity investors is that these people are exactly the people that could and would drive growth in portfolio companies.

This group of people is not limited to former founders of successful tech businesses who may have received life-changing amounts of wealth and are unlikely to take a new role in an executive capacity. It also extends to others who have seen what can be done in a fast-growth industry; who may be looking either to provide their skills to a business for a shorter time period than a typical private equity investment cycle; who may be looking to engage in multiple roles and projects simultaneously; or who are looking for a role in a business that internally and/or externally aligns with their values – in addition to providing an opportunity to make money.

Searching for common ground
This issue for the private equity investor materialises when negotiating equity terms. If the terms offered require the individual to remain in the business for three to five years on an exclusive basis to realise his or her returns, they may be less enthusiastic than the investor was expecting. In these circumstances, an investor may look to compromise on certain points or positions – including the amount of upfront financial contribution from the individual.

Even where the manager can be persuaded to sign up on this basis, the reduced amount of skin in the game can actually be self-defeating. Even if a reduction in contribution is offered without a corresponding reduction in potential future proceeds, the perceived value loss suffered if the individual does look for fresh opportunities may not be sufficient to retain them. Given the diverse nature of the businesses in the TMT space, even a tightly worded non-compete may not apply to restrict the change of role.

To attract the best people for specific roles in certain sectors, it may be that private equity investors need to consider alternative remuneration and incentivisation packages to reflect valuable contributions, even if this does not line up with their own period of ownership. If this is to remain equity-based, it could lead to a further increase in vesting and similar arrangements being applied to sweet equity and a softening of the terms of any such vesting.

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