1. Introduction
Private equity (PE) sponsors and portfolio companies increasingly operate across borders, raising questions about how to structure management incentives when US funds acquire European companies, or vice versa. The challenge is to align management with investor returns while navigating different tax regimes and market practices.
The core objectives remain consistent on both sides of the Atlantic. Investors want management to have ‘skin in the game,’ preferring appreciation-based rewards that ensure management benefits only when investors achieve meaningful returns. What differs are the vehicles used to achieve this. Profits interests dominate in the US for senior executives, while Western Europe frequently uses ‘sweet equity’ or growth shares. These differences arise from distinct tax environments, market practice and regulatory approaches to taxing partnership interests and capital gains.
This article examines the primary management incentive structures in US and Western European PE transactions, the tax treatment driving design choices, standard commercial terms including leaver provisions and vesting, economic considerations, and cross-border harmonisation challenges.
2. US Management Incentives
2.1 Shifting from Stock Options
Stock options dominated US executive compensation for decades and remain useful for mid‑level employees, but in PE-backed companies have largely fallen out of favour for senior executives. The ability to use options in a tax-efficient way is more limited. While incentive stock options (ISOs) may offer favourable tax treatment, they face strict limits and requirements (e.g., exercise and holding period requirements prior to a sale, and only $100,000 in value can become exercisable annually). The other type of options, non-qualified stock options (NSOs) provide more flexibility but trigger ordinary income tax on the spread at exercise. Stock options also pose challenges when an executive departs before an exit event: typical post-employment termination 90-day exercise windows (required for ISOs) forcing the executive to fund both the exercise price and tax withholding to acquire shares in an illiquid private company.
In light of these considerations, PE sponsors in the US have shifted toward profits interests for senior management, which eliminate the exercise decision and attendant cash outlay requirement while providing preferential tax treatment. In today’s market, well-structured profits interests have become standard for recruiting top talent.
2.2 How Profits Interests Work
Profits interests represent an interest in a partnership or limited liability company (LLC) that participates only in future appreciation above a specified threshold, delivering economics similar to stock options but with better tax treatment and no exercise complications.
2.2.1 Structure and Tax Treatment
Profits interests can only be issued by pass-through entities. The portfolio company must establish a partnership or LLC, typically as a holding company above the operating business. Even if the operating company is a C-corporation, sponsors create partnership-level holding companies to issue profits interests, accepting added structural complexity for substantial tax benefits.
Under Internal Revenue Service (IRS) Revenue Procedures 93-27 and 2001-43, properly structured profits interests generate no taxable income at grant or vesting, provided: (1) the partner receives only a profits interest and would receive nothing on an immediate liquidation after grant; (2) the interest does not relate to a substantially certain and predictable income stream; (3) the partner does not dispose of the interest within two years; and (4) the partnership is not publicly traded. At exit, the value realised is taxed as long-term capital gains (currently 20% federal rate plus 3.8% net investment income tax) rather than ordinary income (up to 37% federal). Compare this to non-qualified stock options, where the spread at exercise is taxed as ordinary income, with only subsequent appreciation (if shares are held 12 months+) qualifying for capital gains treatment. Profits interests eliminate this two-stage taxation and treat the entire value realised at exit as long-term capital gains.
It is customary for US executives to make Section 83(b) elections within 30 days of grant of a profits interest, which commences the capital gains holding period immediately on grant and secures capital gains treatment on the (typically zero) fair market value. This is equivalent to the position in the UK, where executives typically make Section 431 elections, which fix the income tax charge at acquisition so that any future growth in share value is subject to capital gains tax.
Properly structured profits interests generally fall outside Section 409A of the Internal Revenue Code, which imposes strict rules on non-qualified deferred compensation. Avoiding these restrictions gives sponsors considerable flexibility in plan design, particularly around acceleration provisions and distribution timing.
2.2.2 Distribution Mechanics
Profits interest holders participate only above a specified threshold or hurdle (the ‘hurdle rate’), required to be set at or above the company’s liquidation value (e.g., the fair market value) on the grant date and customarily includes an additional annual preferred return (often 8-10% annually). The partnership or LLC operating agreement will establish a distribution waterfall: first, to investors until they receive the return of their invested capital (inclusive of any preferred return embedded in the hurdle rate) and second, to both the capital interest holders and profits interest holders rateably based on their percentage interests. This waterfall ensures vested profits interest holders participate only after capital interest holders receive their invested capital and preferred returns.
2.2.3 Why Management Prefers Them
For executives, the appeal extends beyond tax efficiency to simplicity at departure. Unlike option holders who must outlay cash to exercise the option within a limited period of time after departure, profits interest holders wait for a liquidity event. Their interests remain outstanding (subject to vesting and applicable leaver provisions) and participate in distributions when and if a liquidity event occurs, eliminating the exercise decision, cash outlay requirement, and immediate tax bill.
2.2.4 Trade-offs for Sponsors
Sponsors accept several drawbacks with profits interests. First, they lose the compensation tax deduction available with stock options, as the value delivered through profits interests is not deductible as a compensation expense (although in a partnership which provides management with profits interests, PE sponsors and their investors will not be taxed on distributions payable to the profits interest holders). Secondly, profits interest holders may be treated as partners for tax purposes rather than employees. Unless structured properly, this would convert what would otherwise be salary into self-employment income, potentially resulting in the loss of eligibility for certain employee-only benefits (such as tax-free cafeteria plans) and creating administrative complexities. However, there are tax efficient structural mechanisms available to bifurcate management’s employment income and profit participation.
Additionally, because partnerships are pass-through entities, profits interest holders are taxed annually on their share of partnership profits whether or not cash is distributed, creating potential ‘phantom income’ on which executives may face a substantial tax liability without receiving cash to pay it. To address this, partnership agreements typically include tax distribution provisions requiring annual cash distributions sufficient to cover the partners’ expected tax obligations, which are then offset against future profits interest distributions.
In light of these considerations, sponsors typically limit profits interests to senior management (the top 5-15 executives), while broader employee populations receive awards structured as phantom equity or stock options.
3. Western European Management Incentives
3.1 The Landscape
In Western European PE transactions, the core management incentive for senior executives is delivered through ‘sweet equity’ or, increasingly, growth shares. While stock options, restricted shares or share units and phantom equity are common in other private company contexts (particularly for broader employee populations or in non-PE backed companies), PE sponsors overwhelmingly favour sweet equity structures. Some jurisdictions offer statutory tax-advantaged vehicles, such as the UK’s Enterprise Management Incentive (EMI) options, though eligibility criteria generally exclude PE-backed companies.
Sweet equity provides the flexibility and economic alignment that sponsors require while achieving capital gains tax treatment, albeit through fundamentally different mechanics than US profits interests.
3.2 Understanding Sweet Equity and Growth Shares
Traditionally, the equity structure in PE-backed transactions consists of a combination of ordinary shares along with stapled preference shares or loan notes (the ‘institutional strip’), plus an additional pool of unstapled ordinary shares which constitute the ‘sweet equity’. On a transaction, management are expected to re-invest a portion of their transaction proceeds into the institutional strip, to give them ‘skin in the game’ alongside the acquiring sponsor, and will then receive the additional sweet equity as the incentive component.
The preference shares or loan notes, with priority over the ordinary equity, are repaid first on an exit, before the excess value flows to the ordinary holders. This seniority, combined with the gearing in the ratio of preference shares to ordinary shares, often at up to 99:1, provides the incentive to management to drive the value of the business to exceed the preferred returns, which in turn drives the value of the ordinary equity. This back-end distribution mimics the economic effect of a profits interest waterfall, and allows management to realise significant value as the value of the ordinary equity grows, but achieves it through a corporate capital structure rather than partnership allocation rules.
A common alternative to the traditional sweet equity structure is the use of ‘growth shares,’ a class of equity with inherent economic rights that entitle the holder to participate in the value realised in excess of performance thresholds, normally defined as internal rate of return (IRR) or multiple on invested capital (MOIC) hurdles. As with traditional sweet equity, management acquire this equity upfront, but at a price that reflects the valuation of the growth shares being depressed by the inherent performance hurdles. On an exit, the value realised is distributed between the investors and the growth shares according to the equity waterfall which embeds the IRR or MOIC thresholds.
A similar concept existed in the US during the late 1990s and early 2000s called ‘leveraged equity,’ where preference structures and performance returns were built into equity instruments. However, in the US, this practice largely disappeared following the ability to use profits interests and the introduction of Section 409A and associated equity valuation considerations.
Unlike US profits interests, which avoid taxable income at grant and vesting through partnership tax treatment and distribution waterfalls, ‘sweet equity’ and ‘growth shares’ require management to acquire equity, and therefore make an actual capital investment, albeit with the intention that management can invest at an acceptably low valuation because of the design of the capital structure.
3.3 Why Management Must Pay
Generally, Western European tax authorities do not have an equivalent framework to the US partnership tax rules and IRS guidance that permits granting profits interests without triggering taxable income at grant or vesting and, therefore, cannot replicate the US approach of issuing equity incentives that avoid upfront tax charges based solely on the waterfall position. Instead, management must actually purchase shares to secure capital gains treatment on future appreciation. This means that the fair value of the shares at the time of acquisition becomes key to the tax analysis. If management pays fair value, future appreciation qualifies as capital gain. If they pay below fair value, the discount may be taxable as ordinary income at purchase.
Western European tax valuations consider multiple factors, including forecast performance, so while the seniority of the preference share, the debt funding, or the hurdles in-built in growth shares, will depress the valuation, equity being only ‘at the money’ at grant does not mean zero value. Consequently, managers may require loan support to subscribe for sweet equity. If new managers join later in the investment cycle, valuations may become prohibitively high, requiring alternative solutions.
The need for managers to acquire equity is one reason why traditionally sweet equity participation was restricted to senior managers, with cash-based incentives for broader employee populations. However, wide‑based management equity structures are increasingly common, sometimes with hundreds of employees participating.
3.4 European Jurisdictional Differences
Tax treatment varies meaningfully across European jurisdictions and also differs depending on the legal structure used.
In the UK, the tax authorities (HMRC) have agreed a ‘memorandum of understanding’ (MoU) which, where it applies, allows managers acquiring traditionally-structured sweet equity upon deal close to be treated as acquiring the shares for fair value, provided they are paying the same price per ordinary share as the institutional investor (often a nominal value). However, several conditions must be met for this safe harbour to be engaged, and it will not apply to a growth share construct. Where it cannot be relied on, a tax valuation of the sweet equity is required.
The MoU is not applicable in Continental European jurisdictions. Moreover, beyond different valuation standards, some jurisdictions, such as Spain and Italy, examine not only the legal structure and valuation but also the commercial terms of the incentive to determine whether the arrangement constitutes capital investment rather than remuneration for services.
3.5 Economic Participation at Exit
Both sweet equity and US profits interests typically operate on an exit-only model. Management holds actual shares from day one, subject to vesting conditions and leaver provisions, but often has no right to sell or obtain liquidity until an exit event occurs (a sale or similar transaction or, often, an IPO). This structure ensures management’s economic interests are tied exclusively to the ultimate exit outcome.
Under a traditional sweet equity structure, the ordinary equity, including the sweet equity, only participates in excess proceeds after the invested capital plus preferred returns are paid on the preferred instruments within the institutional strip. This distribution pattern mirrors the economics of US profits interests but achieves the result through corporate law priority rather than partnership allocations. An equivalent outcome is achieved through a growth share construct, where the proceeds on an exit are allocated through a waterfall included in the terms of the equity.
3.6 Performance Enhancement Through Ratchets
Western European sweet equity arrangements frequently include ratchet terms that increase management’s percentage ownership if the company delivers exceptional returns. A typical structure might provide that management’s participation remains constant if the exit generates up to a 2.5x multiple on invested capital, steps up by 25% at 3.0x MOIC, and steps up by 50% or more at 3.5x or higher. Depending on sponsor preference, ratchets based on IRR, or a combination of IRR and MOIC, are also common. These ratchets concentrate rewards on management teams that drive value creation while ensuring investors receive priority returns first.
4. Comparison of Standard Terms
4.1 US Leavers
When executives holding profits interests terminate employment, their treatment depends on the circumstances of departure. US arrangements typically avoid explicit ‘Good Leaver’ and ‘Bad Leaver’ labels, instead categorising terminations as: termination without cause, resignation for good reason, voluntary resignation, or termination for cause.
For involuntary terminations without cause or resignations for good reason (a similar concept to constructive dismissal in the UK), treatment is generally most favourable. Vested profits interests typically remain outstanding and callable by the sponsor at fair market value. Unvested profits interests are forfeited. Some arrangements allow vested profits interests to remain uncalled and participate in future distributions, particularly for long-tenured executives.
Voluntary resignation receives varied treatment depending on sponsor philosophy and executive tenure. Common approaches include forfeiture of all interests if resignation occurs before a specified service period (often three to five years), call rights at the lower of fair market value or cost, or retention of vested interests subject to fair market value call rights.
Termination for cause typically results in forfeiture of all interests, both vested and unvested, with many arrangements including clawback provisions for distributions received within a specified period (often 12 to 24 months) before termination for cause.
Most US arrangements include drag-along rights allowing sponsors to compel management participation in exit transactions. Tag-along rights appear less frequently in US deals than in Western European transactions. For equity arrangements other than properly structured profits interests, leaver provisions must comply with Section 409A’s complex restrictions on timing and form of deferred compensation payments.
4.2 Western European Leavers
Western European leaver provisions typically explicitly use ‘Good Leaver,’ ‘Bad Leaver,’ and, increasingly, ‘Intermediate Leaver’ classifications. This structured categorisation reflects both market practice and employment law differences. Western European employees are not employed at-will and can enjoy substantial statutory protections, making termination categories more legally significant.
Where management have reinvested into the institutional strip, their interests are not generally forfeitable (other than, sometimes, in very bad leaver cases), although sponsors increasingly look for call rights at fair value upon termination. If management retain these instruments, associated voting and information rights may lapse.
For sweet equity, as in the US, the definition and treatment of each category continues to vary based on each sponsor’s preferred approaches and the circumstances of the investment and the management team.
Good leaver status typically includes death and disability, and, possibly, other scenarios such as redundancy and retirement. Good leavers generally retain either all or a portion of the sweet equity, subject to sponsor call rights at fair market value, or the higher of cost and market value.
Bad leaver treatment applies to termination for cause, gross misconduct, material breach of contract and, very often, voluntary resignation. Bad leavers typically forfeit all sweet equity, both vested and unvested. Some arrangements provide call rights at the lower of cost or market value rather than outright forfeiture.
Intermediate leaver status, where it is used, gives flexibility to define a treatment falling between good and bad leaver categories. Treatment typically involves forfeiture of unvested shares and call rights over vested shares at fair value or cost, on terms less favourable than good leavers but better than bad leavers. The explicit tiering provides certainty but requires careful drafting to address edge cases fairly.
4.3 US Vesting
Profits interests typically split awards between time-based and performance-based vesting. Senior management typically receive one-third time-based and two-thirds performance-based vesting, reflecting sponsor emphasis on rewarding value creation. For the next level, the split is often 50:50, balancing retention with performance alignment. Time-based vesting typically occurs rateably over four to five years. Some sponsors use annual vesting (for example, 20% per year over five years), which creates retention incentives around anniversary dates. Others prefer quarterly or monthly vesting after an initial one-year vesting date, providing smoother retention incentives. Drafting vesting schedules for profits interests requires careful attention to allocation mechanics. Since partnership profits are computed and allocated annually based on vested percentages, a profits interest that vests incrementally (for example, 2% per year over five years reaching 10%) may require ‘catch-up’ provisions so the holder ultimately receives their full percentage of profits from the grant date. Without catch-up provisions, the holder would only receive their vested percentage each year, resulting in less than the intended economic participation.
Performance-based vesting most commonly is tested at liquidity events rather than annually against operating metrics, reflecting sponsor preference for simplicity and alignment with ultimate investment outcomes. The predominant approach ties vesting to sponsor returns measured by IRR (typically requiring 10-25% annually) and/or MOIC (commonly 2.0x to 4.5x). This ensures management participates meaningfully only when investors achieve strong outcomes.
Some sponsors use annual operating metrics like EBITDA targets with cumulative catch-up provisions, though this is less common because it requires ongoing valuations and creates administrative complexity. Most prefer the simplicity of testing performance only at exit.
Certain plans fully accelerate unvested awards upon sale or IPO, reflecting the view that executives employed through exit have fulfilled their service obligations. Properly structured profits interests avoid Section 409A restrictions, permitting this flexibility without triggering adverse tax consequences.
4.4 European Vesting and Performance Hurdles
Western European sweet equity structures build performance hurdles into the capital structure to control distributions rather than as vesting conditions like in the US. Preference shares carrying 8-12% annual returns create a threshold that ordinary shareholders must clear before participating meaningfully in exit proceeds. This controls distribution economics through capital structure mechanics rather than controlling vesting. Where more flexible performance hurdles are needed, growth shares can embed IRR or MOIC hurdles in the equity terms, operating more like US profits interests.
Vesting in Western European arrangements primarily governs leaver treatment rather than economic participation at exit. For example, an executive with 60% vested sweet equity who remains employed through exit may participate 100% in their ordinary share economics. If that same executive departs before exit, their leaver category (good, bad, or intermediate) generally determines treatment of the vested 60% versus unvested 40%.
4.5 Pool Sizes and Economic Trade-offs
The economic design philosophies diverge between US and Western European approaches in ways that reflect different views about risk-sharing and capital commitment.
Western European sweet equity pools are typically larger (10-20% of ordinary equity versus 5-15% for US profits interests), but context matters: all sweet equity participates only after preference share hurdles are met, with time-vesting governing leaver treatment, while US pools are smaller but typically include a portion subject only to time-vesting, with the remainder requiring performance hurdles (i.e., meeting IRR and MOIC thresholds) to vest.
US profits interests offer more downside protection for executives, requiring no upfront investment and creating no risk of losing contributed capital. This facilitates recruitment but may result in an attenuated ownership mentality. Conversely, Western European sweet equity requires capital commitment that creates true ownership psychology and, depending on the size of the initial commitment, potential losses if deals underperform. The upside profile also differs, with Western European structures often providing greater potential upside through larger pools and performance-linked step-ups.
From the sponsor perspective, US sponsors accept administrative complexity and loss of compensation deductions to provide executive-friendly structures. Western European sponsors expect meaningful capital commitment and focus on hurdle levels, reflecting market norms where management investment is standard practice.
5. Bridging the Atlantic: Practical Implications
For PE sponsors and portfolio companies operating across the Atlantic, the structural differences create practical challenges that extend beyond technical compliance.
The adjacency challenges are acute for global companies with senior management in both the US and Western Europe. No upfront investment is required of a US-based CFO receiving profits interests. Their Western European counterpart purchasing sweet equity may have to commit personal capital or take on debt in the form of management loans (which could run into the hundreds of thousands) with downside exposure. When both serve on the same management team and drive the same business strategy, this divergence can test internal equity principles and create retention risks.
Rollover expectations present another dimension of cross-border tension. When sponsors acquire companies with management equity in place, Western European deals traditionally feature higher and more standardised rollover requirements (often around 50% of proceeds). US rollovers are more individualised and negotiable (typically ranging from 25-75%) and may be required by the sponsor in order to receive a profits interest. For sponsors acquiring businesses with mixed US-European management teams, establishing consistent rollover policies requires careful thought about regional norms and the message that differential treatment might send.
The core insight for cross-border sponsors is recognising that structural differences reflect tax optimisation rather than divergent compensation philosophies. Both models aim for capital gains treatment on appreciation-only returns above meaningful hurdles. The US achieves this through partnership tax principles and distribution thresholds that ensure no liquidation value at grant. Western Europe accomplishes it through capital structure design and share purchase requirements. Neither is inherently superior; each responds to its respective tax environment.
Several developments suggest potential convergence. US sponsors are increasingly incorporating explicit hurdle concepts beyond performance vesting, while Western European deals experiment with reducing management sweet equity subscription costs where permitted. Cross-border PE funds create pressure for harmonisation in plan economics even where legal structures must differ. The most sophisticated sponsors now engage with these challenges proactively during deal structuring rather than treating incentive design as a post-close administrative task.
6. Conclusion
Management incentive plans are integral to PE value creation, translating investor capital into aligned teams driving growth and operational excellence. While US profits interests and Western European sweet equity approaches differ substantially in mechanics, both ensure management invests alongside sponsors, participates only in value creation above meaningful hurdles, and face real consequences for underperformance.
For legal and compensation advisers, the technical distinctions matter. Missteps can trigger adverse tax consequences, unintended vesting outcomes, or compliance failures, including under securities, corporate, employment and deferred compensation regimes. For sponsors and management teams, the critical insight is understanding available tools in each jurisdiction, optimising for tax efficiency and maintaining focus on alignment.
As PE expands globally, we expect continued innovation in incentive structures that balance jurisdictional requirements with cross-team consistency.