“Waterfall Distribution” – What’s That? The Private Equity Pitch to Employees

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A Note to Our Readers: At the time we are posting this Newsletter, the world is encountering the multiple tragedies of the coronavirus experience. We are not writing about workplace issues related to the coronavirus because, frankly, we are not health experts, and there is, it seems, little employees can do to “negotiate” about such issues.

Rather, we have complete faith in the certainty that each day we move one day closer to the end of this terrible time, and that it will, sooner or later, disappear. We have complete faith that we will all eventually return to a degree of normalcy. If we continue to focus on your workplace “navigating and negotiating,” when that sunny day does eventually return, you will be a better workplace navigator and negotiator for yourself and your loved ones.

Al Sklover and “The Working Wisdom Team”

“Waterfall Distribution” – What’s That? The Private Equity Pitch to Employees

“In capitalism, the person with the capital usually gets the ‘ism.”

– Unknown

a. The “Private Equity Pitch” to Employees:

More and more employees are finding their employers being purchased by Private Equity investors. And, too, more and more employees are getting recruited to work for employers who are owned – in part or in whole – by Private Equity companies.

A central element of Private Equity investment is that it plans on (a) purchase of a company, (b) doing all possible – often to the detriment of employees – to make that company seem more valuable to others, who may buy it from them, and then (c) most importantly, they will sell it within a period of three to five years. It is important to remember that the central element of Private Equity investment is that it needs the employees to stay put during that time period, even though salaries may be lowered, benefits may also be reduced, and critical infrastructure needs may be ignored.

To induce employees, managers and executives to accept this employment experience, and to stay with the company even if salaries are reduced and benefits are cut, they are commonly told that they will each reap huge rewards when, a few years later, the company is sold. It “just” requires commitment, lower salaries, diminished benefits, and a whole lot of blind faith.

As part of that “Private Equity Pitch,” employees are provided documents to sign that make them (a) “limited partners” of a limited partnership, or (b) “members” of a Limited Liability Company (usually called an “LLC” for short). This way, the employees are not “just employees,” but owners, too, and incentivized by the dream of riches. That is the essence of the “Private Equity Pitch.”

The idea is almost always presented this way: “Come aboard, help us build the company (and reduce costs), and after a few years, when we sell the company, you will earn a percentage of the gains when the company is sold.” It is a powerful inducement . . . if things work out as they are presented, all will get rich, including you. For employees, or prospective employees, it is viewed as a veritable “dream come true.”

I am reluctant to say it, but in my 20 years of representing employees in this process, more end up experiencing it as a nightmare than a “dream come true.”

b. What’s “Waterfall Distribution?”

The Private Equity Pitch rarely makes mention of “waterfall distribution,” but that’s what Private Equity professionals call it among themselves. Waterfall Distribution is at the heart of the deal. It means, in general, that:

(1) certain classes of the owners get the best treatment when it comes to distribute the gains from a company being sold, while
(2) other classes of owners get treated less favorably if and when the company is sold for a profit, and, well,
(3) still others get the least favorable distribution of gains, if any are left over after the earlier “classes” are satisfied.

Each “class,” layer or “tier” gets different treatment regarding (a) how much of the gains from the business sale is theirs, (b) what those “gains” include, (c) who gets paid first, and who gets paid last – if at all.

Imagine a cascading waterfall, with a series of levels or tiers. It looks something like this, with the water going over the waterfall traveling in this direction: → → →

    wwwww → →
    wwwwwwww →→→
    wwwwwwwwwwwwww →→
    wwwwwwwwwwwwwwwwwwwwwwww ???

However, as indicated above, if there is not enough water flowing, or the flow of water is siphoned off at “higher levels,” the bottom level (or tier) may experience little flow going to it, even, perhaps, entirely “dry times.” So, it is often disappointing for the lowest tier of owners or classes of interests, in a Private Equity partnership or LLC. And can you guess what “tier” of interests the employees are usually given? Yes, you guessed it . . . the lowest tier.

c. Who Decides Which “Limited Partners” or “Members” Get Best “Class” Treatment?

Private Equity owners are the people who assemble the capital to invest to buy the company, and are those who make the distribution determinations. Almost always, the gains are allocated: (1) best to them, (2) next best to large investors, (3) less good to the most senior executive(s) of the company, and (4) least of all, to the employees who “kept the place running.”

Sophisticated investors are quite familiar with “Waterfall Distribution,” and usually have lawyers, accountants and investment advisors who can guide them through the process of understanding and negotiating the level – or tier – into which they are situated. Employees who are working for an employer that is “invested into” by a Private Equity investment group usually do not have those resources, and for that reason, have little or no “sway” to determine the treatment they will receive.

d. Note: Most “Waterfalls” have Hidden and Harmful Currents and Whirlpools.

Generally speaking, there are four types of documents that employees of a Private Equity-owned or -controlled company are required to sign, and by doing so agree that their “investment” is subject to:

    1. Employment Document: An Offer Letter or Employment Agreement with the employer;
    2. Grant Agreement: A “Grant Agreement” of “Award Agreement” that governs the terms and conditions of the classes of interests – sometimes called “Incentive Units” or “Membership Interests” – and the many ways the employees may lose these, including among them if they are terminated or if they resign, or otherwise violate any workplace rule. (This is often not with the employer, but with the Private Equity firm).
    3. Plan: The set of rules that says what “class” each “owner” is in, and what each “class” of ownership gets when the company is sold; and
    4. Operating Agreement: That is, the Limited Partnership (“LLP”) Agreement of the Private Equity owners group if the investment is structured that way, or perhaps an “Operating Agreement” if the investment is structured as a Limited Liability Company (or “LLC”).

This is the most dangerous, hidden “current” or “whirlpool”: Often making matters worse is that the “Private Equity Papers” employees are given to sign almost always provide that the Private Equity Investors can later change those allocations, and then make the “waterfall distribution” even more in their own interests, usually without their having to tell the holders of the interests “lower” than their own – what some call “downstream” – that they’ve done so.

e. Note, too: These Waterfalls can Change Shape, Without Your Being Told – Yikes!

By this I mean that of the four types of documents that determine the treatment of employees who “sign on,” noted above, may contain hidden or disguised (a) non-compete obligations, (b) clauses that permit the “higher investors” to purchase the employees’ interests for little or no money (commonly “Repurchase Rights” or “Reverse Vesting”), or (c) the ability to terminate the employees at any time, even just before they become entitled to be paid for their long-term efforts to build the company.

f. It’s All There in the “Private Equity Papers,” although often Hidden, Disguised and Buried.

That’s the problem: “it’s all there,” it’s just that (a) the documents are dense and difficult to read, (b) the documents use words, phrases and definitions that are like a blizzard of snow, (c) the documents can be later amended, and (d) everything is subject to the employee remaining employed, which is often not within her or his control.

Though I’ve done this work for almost 40 years, I still find these documents very hard to read, understand and respond to. They are densely written, often containing “trap door” language, and take a long time to understand. Believe me: that’s intentionally the “game.”

WHAT YOU CAN DO: Simply put, negotiating and navigating with Private Equity investors is a tough “game” to play. As the investors usually either own or control the employer through its Board of Directors, it may be that, if you don’t “sign on the dotted lines” of their papers, you may not get to remain on the job, or get the job if you don’t already have it. They employ large law firms with little, if any, concern other than their own interests; fairness to most Private Equity firms, and their law firms, is nothing more than a child’s fairytale.

All of this “gloom and doom” aside, all is not lost; keep the faith. There are, indeed, things you can do to help yourself if you are facing employment by a Private Equity-owned or controlled employer:

    1. If you are a Senior Executive or have Truly Critically Needed Skills, you can and should hire experienced counsel to negotiate on your behalf. The Private Equity firms are entirely full of those who believe they are the smartest people in the room, if not the universe, and often fall prey to their own hubris. There are not too many employment attorneys out there who understand these things, but they are there.

    2. If you are not a Senior Executive, or Not Viewed as Critically Needed, you can consider “banding together” with others on your level; simply put, there is strength in numbers. More than one employee can get together to hire counsel to assist them in moving forward. And where there are numbers, there is strength. Don’t forget that the Private Equity Investors and the lawyers know nearly nothing about running the company, and need you and your colleagues to do so for them. Many even know nothing about your entire industry.

That said, don’t be surprised if colleagues would rather just “sign and hope.” That is very common.

    3. BY EMAIL, always ask for a copy of “All documents that need to be reviewed.” Such a request will often be ignored, but it will transmit the signal that you are not ignorant, not afraid, not someone who signs whatever is put in front of their eyes, and – perhaps most importantly – not entirely in awe of the fairy tale story put in front of you during the “Private Equity Pitch.”

Don’t become disillusioned if this is not granted; it is worth requesting, and may later set the table if you were hoodwinked, to show you were denied critical data needed to understand what you signed.

    4. BY EMAIL, always request that sufficient funds be provided to enable you to hire an attorney to review the documents. As above, you won’t get this unless you ask, and if you are turned down in this request, once again, a record has been that you were denied critical counsel upon which to proceed.
    5. Even just getting some protections is better than getting none. You might request, and you might get (a) a larger share of the “pie” upon sale of the company, (b) removal of non-compete obligations, (c) any mention of repurchase rights, (d) written requirements that you will receive notice of changes to the documents, (d) vesting of your interests to continue if you were later terminated without “Cause,” (e) better terms of employment, and/or (f) other interests, advantages and protections that are valuable to you.

In Summary . . .

Being faced with purchase of your employer by a Private Equity firm, and hearing the “Private Equity Pitch,” can be daunting. The documents are confusing, and needed information can be hard to come by. This is one situation where I do almost always recommend hiring Legal Counsel to, at the very least, review the “papers,” and guide you. Hiring an attorney with others is also a possibility in order to share the costs. Nothing about this experience is “easy,” but, hey, you can do it. Many do it with far more success than they thought was possible.

P.S.: If you would like to speak directly about this or other subjects, I am available for 30-MINUTE, 60-MINUTE, OR 120-MINUTE TELEPHONE CONSULTATIONS, just [click here.] Evenings and weekends can often be accommodated.

SkloverWorkingWisdom™ emphasizes smart negotiating – and navigating – for yourself at work. Negotiation and navigation of work and career issues requires that you think “out of the box,” and build value and avoid risks at every point in your career. We strive to help you understand what is commonly before you – traps and pitfalls, included – and to avoid the likely bumps in the road. Mindfully taking steps to secure better treatment for yourself and, thus, your loved ones, is always a wise steps to enhance your future.

Always be proactive. Always be creative. Always be persistent. Always be vigilant. And always do what you can to achieve for yourself, your family, and your career. Take all available steps to increase and secure employment “rewards” and eliminate or reduce employment “risks.” That’s what SkloverWorkingWisdom™ is all about.

*A note about our Actual Case Histories: In order to preserve client confidences, and protect client identities, we alter certain facts, including the name, age, gender, position, date, geographical location, and industry of our clients. The essential facts, the point illustrated and the lesson to be learned, remain actual.

Please Note: This Email Newsletter is not legal advice, but only an effort to provide generalized information about important topics related to employment and the law. Legal advice can only be rendered after formal retention of counsel, and must take into account the facts and circumstances of a particular case. Those in need of legal advice, counsel or representation should retain competent legal counsel licensed to practice law in their locale.

Sklover Working Wisdom™ is a trademarked newsletter publication of Alan L. Sklover, of Sklover & Company, LLC, a law firm dedicated to the counsel and representation of employees in matters of their employment, compensation and severance. Nothing expressed in this material constitutes legal advice. Please note that Mr. Sklover is admitted to practice in the State of New York, only. When assisting clients in other jurisdictions, he retains the assistance of local counsel and/or obtains permission of local Courts to appear.  Copying, use and/or reproduction of this material in any form or media without prior written permission is strictly prohibited. All rights reserved. For further information, contact Sklover & Company, LLC, 45 Rockefeller Plaza, Suite 2000, New York, New York 10111 (212) 757-5000.

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