Selling a stake or control: Somes things we wish clients knew earlier

As sophisticated as the alternative investment management industry has become over the last 20+ years, we still see a large percentage of firms that are not aware of, or have delayed, taking steps that would make selling all or part of their business easier and save on taxes.

Don’t let due diligence delay a deal

Understand what deal due diligence of your firm will look like. Clients are often underprepared in the following areas:

• Financial books and records. Books and records should be tidy and organized. Red flags should be addressed (e.g., late financials, aggressive business expensing, deficient evidence of capitalization and ownership). Audited management company financials are not necessary, but they will inevitably ease the due diligence process and should reduce the likelihood of a re-trade on price (assuming other unknown issues are not discovered later). Careful consideration should be given to preparing a sell-side quality of earnings report, particularly in an auction process.
• Key personnel. Key roles (COO, CFO, GC, CCO) should be the responsibility of individuals with appropriate experience and tenure for the applicable role. More times than we would admit, we have seen college roommates and relatives of the founder on their fourth career serve in one of these roles. This is not confidence-inspiring to a prospective buyer.
• Compliance and record keeping. Controllable business risk is within the purview of compliance. A recent US Securities and Exchange Commission (SEC) examination tends to put the compliance house in order. If your firm has not gone through an SEC exam, it is a wise move to undergo a mock examination well before buyer due diligence starts (even better, a year before seeking a buyer). For targets registered with the SEC, ensure that records that support the findings of your annual compliance reviews were completed in a timely manner, because those will be important features in any regulatory diligence by the buyer. We have seen deals delayed for weeks – and poor impressions on a buyer made – when compliance appears to be a low priority. Compliance red flags frequently turn into financial issues, triggering additional buyer-requested terms such as (potentially) significant escrows and holdbacks.
• Client buy-in. Understand that direct client (and fund investor) consents will influence deal messaging. Control sales, as well as many minority and stake sales, require direct client and fund investor consents prior to being able to close. While a high percentage of direct client and fund investor consents are obtained in all manager deals, direct clients and fund investors expect to see that the deal will be at least neutral to, if not better for, the firm’s investment team, infrastructure, and operations (e.g., retention of key people, more resources for the manager).

Focusing on these issues before a deal gets rolling will save time and money when a transaction progresses. We have seen too many situations where clients have not adequately prepared for buy-side diligence or considered what the deal messaging will be until they have a deal in sight. This inevitably leads to delays and increased transaction costs.

Understand the tax planning and get it done well before seeking a buyer

If your plan is to have some or many employees participate in sale proceeds (as a reward/bonus or earn-out, or as part of a long-term incentive plan), the most valuable move you can make is to expand ownership (whether actual or phantom) well in advance of the sale event – years before, if possible.

The concept is simple: Anyone whom you want to have participate in sale proceeds needs equity to sell (and profit-only partner status may not be sufficient).

• The holder of that equity is rewarded with a gain in a sale transaction – ideally long-term capital gains treatment.
  • There will likely be no long-term capital gains if the equity is issued less than three years before a sale.
  • The issuance of equity at a discount to value could trigger a tax liability for the recipient.
• It is not market (save for a few exceptions) to ask employees to purchase equity in their firm. Equity awards (structured to be tax-free at issuance) are much more prevalent.
  • Equity is usually nonvoting and subject to forfeiture upon departure.

There are alternatives to equity awards, but they come with tradeoffs:

• A phantom equity plan can be implemented as alternative to real equity issuances and can achieve ownership-like objectives. However, these plans are unlikely to be as tax-advantaged as real equity.
• Special bonuses in connection with a sale are another alternative but generally will not have equity-like features. They will also be tax inefficient (no long-term capital gains and possibly not fully deductible).
• Deal-related bonuses (often paid over time post-closing) are ultimately a deduction from purchase price. Their timing, control over administration, deductibility, and tax withholding will need to be negotiated with the buyer and addressed in the deal documents.

The morale, expectations, and motivation of the nonequity recipients can also become a problem. We have seen key employees become resentful of the tax inefficiency of nonequity alternatives at a time when the founders need them to be excited and incentivized about a deal. And very often key employees who receive equity (or phantom equity) awards are a very important component for a successful transaction. If key people are unhappy about missing out on the materially lower long-term capital gains rates, that can strain the transaction process.

You would be amazed at how many important employees (and partners!) are excluded from participating in sale proceeds as a result of a lack of foresight on ownership issues.

The solution: Adopt an equity issuance plan early

• At first, most clients are reluctant to broaden equity ownership beyond the founder(s) or a very small senior group. However, partnership agreements provide tremendous flexibility. Done properly, a partnership agreement can enable the firm to have its cake and eat it too:
  • Key employees can be given ownership and related incentives early, laying the groundwork for a tax-efficient transaction for all stakeholders.
    • As a firm grows in value over time (hopefully), the employees participate in that new value at the time of the sale (and can be overallocated that value to catch them up to full value, if desired).
    • The three-year capital gains rate holding period starts at issuance.
  • The equity can have special terms, such as time and/or performance-based vesting, and can be designed to mimic a restricted stock unit.
  • To protect the downside, those incentives can be designed to be taken away or discounted if the employee fails to perform as incentivized.
  • Forfeiture of some (or all) equity if an employee leaves the firm before a sale is also a prevalent feature.
• Many clients utilize an employee investment vehicle (EIV) to issue the equity.
  • An EIV is a partnership or LLC that owns the equity in the firm. The employees own interests in the EIV. Effectively, the employees own firm equity indirectly.
  • This means that the employees do not have direct rights under the firm’s partnership agreement. The EIV does, but the founder or principal owners control the EIV.
• In many if not most cases, we have found that equity issuance early (with conditions) is a better approach than delayed or last-minute planning.
• We work with executive compensation consultants such as our affiliate Eisenhandler & Co. to help our clients design an appropriate equity or nonequity alternative plan.

See our other publications, including Looking ahead: Asset manager M&A in 2026, or contact us for more information about investment manager M&A deal terms and negotiation points.