As published in Smart Business on February 24, 2020
C-suite level co-investment is a powerful tool, with at least three significant benefits: enhanced financial alignment between C-level leaders and their sponsor, additional wealth creation leverage for the executive and a powerful career decision litmus test.
Despite these benefits, utilization of co-investment is spotty across the middle market. Some funds do not require it, and many executives hesitate to write a check. That said, we believe that co-investment should be seriously considered every time a C-suite leader joins a private equity-backed portfolio company.
Equity grants create foundational alignment between sponsor and executive by ensuring that all parties mutually profit from value creation and a successful exit. However, alignment becomes emotionally and financially real when an executive makes a personally meaningful co-investment into a deal.
By putting skin in the game, the executive becomes emotionally invested in the company as a co-owner. The concept of “going into business with a sponsor” is a powerful signal to the private equity firm that the executive is fully committed.
Co-investing is also a tax-efficient wealth creation tool. After all, what better way to beat the market than to outperform it through one’s leadership? Because most option grants result in ordinary income tax treatment, co-investing can lower the blended tax rate at the liquidity event.
In our experience, savvy private equity operators insist on maximizing their upside while diversifying their own portfolios by placing a personally meaningful financial bet on themselves. For reference, middle-market co-investment ranges for CEOs are typically between $100,000 and $500,000, while CFOs often land in the $25,000 to $100,000-plus range.
Many successful candidates are facing cash flow pressures such as college tuition and other expenses that impact liquidity. In these and other cases, we suggest a self-directed IRA. This tool, which reclassifies a traditional IRA, allows an individual to deploy IRA funds into a private deal without sacrificing any tax-deferred benefits.
Finally, co-investment is a powerful career decision litmus test. When C-level leaders hesitate here, all parties should pause to ensure a legitimate fit. Presumably, a C-level leader accepts an equity-backed role based upon the belief that they will increase the value of the asset.
An executive who does not insist on co-investing may be signaling doubt in the investment thesis or their own capabilities. In such a situation, we advise that the executive think twice about whether the opportunity is truly the right move for their career; if not, it is better for all parties to walk away rather than risk a failed C-level hire.
One important caveat before co-investing: Executives must conduct thorough due diligence of a portfolio company’s financial performance, customer concentration risk and macro factors, among other areas, before embarking. Further, an executive may be wise to pass on investing in a dire turnaround situation. That said, and for most deals, we advise both sponsors and portfolio company executives to seriously consider, if not require, co-investment as part of onboarding a new C-suite leader.