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Golden rules

US private equity firms ignore ‘golden parachute’ rules at their peril.

In private equity, finding and keeping the right management is paramount, and central to this task is proper incentives, meaning money. While in theory making large payments to key executives upon a change of ownership in the portfolio company is a great way to keep these executives focused on a successful exit, in practice, poorly structured ?golden parachute? payments can lead to tax penalties, bemused buyers and embarrassment.

Golden parachute rules in the US have been around since 1984, but the Internal Revenue Service did not formalize regulations until 2004. The heat increased last year when the IRS released a guide for audit examiners specifically to deal with golden parachute situations.

In a recent paper, Lowenstein Sandler lawyers Edward Zimmerman and Brian Silikovitz, together with Mobius Venture Capital managing director Jason Mendelson, argue that many private equity firms may be unaware of the consequences of golden parachute rules.

When a company grants an executive a large ?parachute? payment upon a change of control in the company, the acquirer may be unable to deduct this payment as a compensation expense. What 's more, the rewarded executive in question may also have a 20 percent penalty withholding tax imposed on him or her. These rules can be triggered not only upon the sale or initial public offering of a company, but when just 20 percent of the company is acquired and an executive's pay is increased.

The authors of the paper suggest that golden parachute rules be considered early in the life of an investment, and give specific advice on how best to avoid these expensive penalties:

  • ? If the golden parachute payments are paid by a non-public corporation, the rules are not triggered if, immediately prior to the change in control, 75 percent of the shareholders approve the payments. This becomes tricky because the vote is not sufficient unless the shareholders receive adequate disclosure, which may not be possible if the approval is made long before the change in control. There is a risk that if the vote is delayed until just prior to the change in control, the shareholders will not approve it.
  • ? Any golden parachute payments agreed to within a year before a change in control are presumed to trigger the rules. Therefore these arrangements should be set as far in advance as possible.
  • ? Be careful of accelerated vesting plans, which can trigger the golden parachute rules at or prior to a change of control in the company.
  • ? Beware of ?gross-up? arrangements, whereby a portfolio company essentially pays enough to cover the personal golden parachute penalty tax. This arrangement still does not allow the acquiring corporation to take a compensation expense deduction, and could be quite expensive.
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