The sponsor's model often shows equity before the management incentive plan, and the plan's structure, not its headline percentage, decides what the co-investor gives up.
A management incentive plan dilutes the co-investor exactly as it dilutes the fund: by the plan's payout at exit, borne pro rata. On an illustrative 300.0 equity investment exiting at 750.0, a 10 per cent pool of options struck at the entry value takes 45.0 and cuts the multiple from 2.50x to 2.35x, about 148 basis points of IRR. The same 10 per cent as full-value shares takes 75.0 and leaves 2.25x, so the structure matters as much as the percentage.
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Co-investors usually underwrite from the sponsor's model, and sponsor models are often built on equity value before the incentive plan, with the plan shown as a line in the waterfall or left to the term sheet. The co-investor then reads a gross multiple that no shareholder will receive. Rebuilding the plan is a short calculation, provided the plan's structure is known.
| Input | Value |
|---|---|
| Equity invested by fund and co-investors | 300.0 |
| Co-investor's share | 10%, 30.0 |
| Exit equity value, before the plan | 750.0 |
| Hold | 5 years |
| Gross multiple and IRR before the plan | 2.50x, 20.11% |
| Incentive pool | 10% |
| Ratchet: pool rises to 15% if investors make at least | 3.0x |
Full-value shares: MIP = pool × exit equity
Options at entry value: MIP = pool × max(exit equity − invested, 0)
Options with a hurdle: MIP = pool × max(exit equity − invested × (1 + h)n, 0)
In Excel, options: =Pool*MAX(Exit_Equity-Invested,0)
| Structure | MIP payout | To investors | Multiple | IRR | Co-investor receives |
|---|---|---|---|---|---|
| No plan | 0.0 | 750.0 | 2.50x | 20.11% | 75.00 |
| Full-value shares | 75.0 | 675.0 | 2.25x | 17.61% | 67.50 |
| Options at entry value | 45.0 | 705.0 | 2.35x | 18.64% | 70.50 |
| Options, strike accreting at 8% | 30.9 | 719.1 | 2.40x | 19.11% | 71.91 |
Full-value shares, such as restricted stock granted at no cost, take 10 per cent of everything: 75.0, which is 16.7 per cent of the 450.0 gain. They pay management even if the company is sold at cost. Options struck at the entry value, or profits interests with a threshold equal to entry, take 10 per cent of the gain only: 45.0, cutting the IRR by 148 basis points. A strike that accretes at 8 per cent a year rises to 440.8 by exit, so the plan takes 10 per cent of 309.2, or 30.9, and the cost falls to 101 basis points.
The accreting strike behaves like a preferred return for investors: management earns nothing until the investors' equity has compounded at 8 per cent a year, and then shares only in the value above that line. It costs investors less in a good outcome and nothing at all in a mediocre one. Below an exit of 440.8, an exit that would still return 1.47x gross, the hurdle plan pays nothing while the entry-value options plan already pays.
The co-investor's share of each is a tenth: 7.50, 4.50 or 3.09. Its multiple and IRR are identical to the fund's, because both hold the same ordinary equity.
Ratchets are common in sponsor-backed plans: management's share steps up when investors clear a return. Here the pool rises from 10 to 15 per cent if investors still make 3.0x after the higher payout. That test creates a discontinuity. Below an exit of 1,005.9, management takes 10 per cent of the gain, 70.6, and investors receive 935.3, 3.12x. At 1,005.9 the 15 per cent pool becomes affordable, management takes 105.9 and investors receive exactly 900.0, 3.00x.
One more unit of exit value moves 35.3 from investors to management, 3.53 of it from the co-investor. Investors only get back to 935.3 at an exit of 1,047.4, another 41.5 of value created entirely for the plan.
| Exit equity | Gross multiple | MIP payout | Investor multiple | Without ratchet | Co-investor receives |
|---|---|---|---|---|---|
| 300.0 | 1.00x | 0.0 | 1.00x | 1.00x | 30.00 |
| 450.0 | 1.50x | 15.0 | 1.45x | 1.45x | 43.50 |
| 750.0 | 2.50x | 45.0 | 2.35x | 2.35x | 70.50 |
| 1,050.0 | 3.50x | 112.5 | 3.13x | 3.25x | 93.75 |
An options plan costs nothing in an exit at cost and takes a growing share of the gain as the deal does well; the ratchet only bites in the best outcomes. The cost to a co-investor is therefore concentrated in the scenarios that justified the deal, which is why it belongs in the base case rather than a footnote.
Ask what has been granted and what is reserved. An unallocated part of the pool can be granted later at a strike below the eventual exit value, at the board's discretion. Model the full pool, not only the awards already made.
Get the plan's terms with the information memorandum, compute the payout at three exits and underwrite on equity after the plan. On this case the co-investor's 2.50x is 2.35x, and 3.50x is 3.13x once the ratchet bites. The return bridge in the free companion files for this book lists the modelling traps a co-investment memo should clear. For the other layers between the deal's gross return and yours, see how much worse co-investment deals can be, what deal-by-deal carry costs a co-investor and what transaction and monitoring fees cost a co-investor.
No. Pools are quoted as a percentage of the equity, but the structure decides the cost. In the illustrative case, a 10 per cent pool costs investors 45.0 of a 750.0 exit if it is options struck at the entry value, 75.0 if it is full-value shares, and 30.9 if the strike accretes at 8 per cent a year.
Yes, pro rata with the fund, because the plan dilutes every ordinary share the investors hold. A co-investor with 30.0 of a 300.0 equity cheque bears 10 per cent of the plan: 4.50 at a 750.0 exit under options at entry value, cutting its multiple from 2.50x to 2.35x, the same as the fund's.
A clause that raises management's share when investors reach a return threshold. In the illustrative case the pool rises from 10 to 15 per cent if investors still make 3.0x after paying it. That creates a cliff: at a 1,005.9 exit management's payout jumps by 35.3 and investors fall from 3.12x to 3.00x, recovering only at a 1,047.4 exit.
This article is one calculation from The Co-Investment Practitioner. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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