Does 'Skin-in-the-Game' Really Work?

Private equity Groups (PEGs) have a very successful model. Leverage access to equity and debt capital and acquire companies with lots of upside potential. Bring in proven, value-centric management to create material equity value via organic and M&A growth. All this with a single focus in mind: exit to pay back its investors.

From a human capital perspective, PEGs often insist that new managers put "skin-in-the-game." A typical approach: a CEO buys around $250K of equity while CXOs buy around $100K of equity.

Replicating the private equity model can be hard

Can a founder replicate the skin-in-the-game PEG model? As they say on TV, don't try this at home without adult supervision. Asking new managers to buy into a founder company (not a PEG) often does not work. Here's why:

  1. PEGs typically have both the control and vision to maximize the value drivers for a company – such as product/service mix, distribution channels, vendor alliances, price reduction, etc. Most founders give this lip service. They are unable to get out of the way.
  2. PEGs are very leveraged so outsized equity returns on equity are possible. Most founder-owned companies have limited debt. So the upside is often limited for the candidate executive who buys in.
  3. PEGs are committed to their exit strategy from the start:  often, get out within 7 years of getting in. A skin-in- the-game executive can see the light at the end of the tunnel from day one. Most founders talk a good game but are not committed to exit unless the total deal works including fitting the founder's next career.
  4. PEGs use skin-in-the-game as a "gate." Founders use it as a validation of their valuable entity which is often counter-productive to a buy-in. The price a founder set may just be too high.
  5. PEGs are willing to take risk and either win or lose. PEGs invest across a number of different companies; not all will win. Founders on the other hand tend to be somewhat risk-adverse since they only have one business and one company. Founders have a powerful urge for self-preservation, often leading to avoiding risk.

The founder approach to strategic incentive

Bottom line: The PEG skin-in-the-game tool box may not fit a founder-based firm. A PEG portfolio company brings an integrated approach for both leadership and capital succession.

On the other hand, most founders seek leadership succession and then figure capital succession out later. Requiring a key executive to put skin-in-the-game to a founder-based firm can easily backfire.

Executives eventually want their money back and often a shareholders' agreement only provides liquidity when an executive leaves. Then the founder is back to square one: no CEO, no succession, and no path to liquidity

Know your options for strategic incentives across true and synthetic equity. Explore skin-in- the-game "lite" strategies that can be much more resilient and effective to fit the needs of founder-based companies.

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