The Co-Investment Requirement in PE-Backed Companies: Becoming an Equity Partner

CEOs and other senior officers of portfolio companies are often asked to become co-investors with the sponsor as part of joining the company. The co-investment requirement is an additional component of the employment package that requires negotiation.

While public company executives are often compensated with cash and equity grants annually, PE-backed executives make co-investments at the outset. Unlike long-term incentive compensation, an executive's co-investment is actual stock or membership interests in exchange for a cash payment made at the start of employment.

In certain transactions, equity holders in the acquired company or those going through transactions—including founders and key management team members staying post-transaction—may be required to co-invest by rolling over ownership stake portions into the new equity capital structure established by the acquiring PE firm instead of receiving all transaction proceeds. This "rollover equity" is attractive to PE investors because it reduces cash outlay and helps align investor and management team objectives.

Protecting Your Equity: Negotiating Pari Passu Rights and Liquidity

Co-investment equity terms should align as closely as possible with other investors. Executives should seek pari passu treatment regarding preferential treatment upon certain corporate events and transactions, and certainly with other management equity holders, such as departed former executives.

Ideally, management equity holders will hold the same tag-along and drag-along rights as other investors, allowing them full participation in any company sale. Similarly, management may press for preemptive rights to invest in upcoming capital raises to prevent dilution of their investment.

Finally, requesting the same piggyback registration rights allows executive equity holders to participate in an IPO on the same terms as majority stakeholders, allowing quicker and more valuable investment liquidity.

Equity Valuation in Private Companies: Access and Audit Rights

Equity valuation in private entities presents greater challenges than in public markets. Because equity value is subject to interpretation, executives should understand how the company will be valued at certain exit and liquidation points and how such valuation is determined.

Legal language in governing documents commonly allows the Board to make good-faith equity value determinations. Executives  should ensure they  have access to the company's books and records and quarterly/periodic financial statements. Additionally, executives should negotiate audit rights to challenge any unfavorable valuation assessments.

Exit Provisions: Protecting Your Investment After Employment Ends

While considering the deal, executives must understand how their co-investment will be treated upon employment separation. If executives cannot retain co-investment post-separation from service, the equity will likely be subject to repurchase rights valued equitably, at minimum price, with the protections noted above.

Given that co-investment equity will be illiquid, executives may seek to put rights on this equity to force interest sales upon separation. While not necessarily common, this can be particularly helpful for allowing clean breaks by taking money out of companies that no longer want to employ them.