A founder I had not spoken with in two years called me a few weeks after his first full board meeting at the company he had sold to a mid-market PE sponsor. He had rolled twenty percent of his proceeds into NewCo equity and the LOI had walked him through the math twice — he was paying tax on eighty percent of the consideration, he was rolling twenty percent, and he was going to own a meaningful single-digit slice of NewCo on a fully-diluted basis. He was comfortable with all of that on signing day. What the LOI never named was the management equity pool rollover dilution in private equity deals that was about to eat three points of his stake before the first board meeting.
At the board meeting the CFO had walked through a slide showing the post-closing capitalization, and on the slide there was a line item — “Management Incentive Plan, 12.5% reserved” — that he had never seen before. The slide showed his rollover equity through an F-reorganization at a percentage materially below the number he had carried in his head since the LOI. He asked the CFO about the line item and got a brief, casual answer about “the standard pool we set up.” He called me that afternoon.
I had to walk him through the conversation he had not had with his counsel at signing. The top-up management equity pool — the “MIP,” in PE shorthand — almost never appears in the LOI. It almost always appears in the closing capitalization. The mechanics of how the dilution gets allocated, and to whom, are the founder negotiation that you cannot fix after the wire hits.
What the management equity pool actually is and why it exists
The MIP is the equity reserved at NewCo for grants to management — typically to the post-closing CEO, CFO, COO, and a handful of key executives. The pool is set up because the PE sponsor wants management aligned with the equity outcome, wants flexibility to attract or replace executives during the hold period, and wants an instrument to grant new joiners without going back to the cap table. None of that is sinister. The MIP is a standard piece of PE deal architecture and would be present whether or not the founder rolled equity.
The size of the pool varies. In small middle-market deals — enterprise value under $100 million — the pool typically sits between five and seven and a half percent on a fully-diluted basis. In larger deals the pool grows to ten to twelve and a half percent, sometimes fifteen. The pool is generally allocated to a profits-interest-like instrument that participates in upside over a threshold equal to the sponsor’s invested capital plus a preferred return, so the MIP grants only have economic value if the deal hits a meaningful return. You can see how sponsors describe these pools in practice in SEC S-4 filings on EDGAR, where MIP structures are routinely disclosed in the management compensation sections.
What founders miss is that the pool is created out of the founder’s rollover percentage as much as out of the sponsor’s percentage. The mechanics are not intuitive, and they are not the same mechanics as the option pool dilution the founder is used to from earlier venture rounds.
How the rollover dilution math runs at closing
The founder’s LOI math usually looks like this: the sponsor is paying X dollars for a hundred percent of NewCo, the founder is rolling Y dollars of value into NewCo equity, and the founder’s ownership at NewCo is Y over X expressed as a percentage. If X is one hundred million and Y is twenty million, the founder owns twenty percent of NewCo. That is the number the founder carries in his head.
The closing math runs differently. The sponsor and the founder agree on the total equity capitalization of NewCo, which includes the sponsor’s contribution, the founder’s rollover, the MIP, and any management co-investment that other executives have committed to. The MIP is generally allocated on a “pre-dilution” basis — meaning the pool sits on the cap table before the closing capitalization is divided between the sponsor and the rollover holders. If the sponsor wants the post-closing common equity to look like sixty-five percent sponsor, twenty percent founder, fifteen percent MIP, the founder’s twenty million has just bought him a smaller slice than the LOI math implied. The arithmetic is straightforward once you draw it out, but it is not the arithmetic the founder did when he signed. The same blind-spot drives the cash-free, debt-free traps founders hit on the wire reconciliation.
The alternative structure — and this is the structure the founder should be pushing for — has the MIP allocated “post-rollover” out of the sponsor’s column. The founder rolls twenty percent into common, the sponsor takes eighty percent, and the MIP is granted out of the sponsor’s eighty percent. The founder still ends up at twenty percent of the common cap table on signing day, and the MIP dilutes only the sponsor’s holding. My commentary on a PE stockholders agreement walks through the variations, but the headline is that the “who bears the pool” question can be a swing of three to four percentage points of the founder’s post-closing equity. On a deal where the founder’s rollover is worth twenty million dollars at signing, that is six to eight hundred thousand dollars of value that the LOI did not address.
Why the LOI is silent
The LOI is silent because the LOI is the document the founder reads. The MIP is the term the sponsor’s deal team negotiates with the sponsor’s tax counsel and management consultants, and the term often does not get reduced to writing until the stockholders agreement and the equity-grant documentation are exchanged in the last two weeks before closing. The founder’s counsel — if the founder has counsel who has not negotiated against this sponsor before — frequently sees the term for the first time when it lands on the table, and at that point the rest of the deal is in motion and the founder is being told that the MIP is “market” and that everyone does it this way.
Whether that is true depends on how you measure “market.” The pool size is market in the sense that PE sponsors universally reserve them. The allocation method — pre-rollover versus post-rollover — is much less uniform than the sponsor will represent. Some sponsors carry the pool entirely out of their own column. Some sponsors split it. Some sponsors push the entire pool onto the rollover holders. The founder’s position is materially different across the three structures, and the founder’s leverage to move from one structure to another is highest at the LOI stage and drops to near zero by the time the stockholders agreement is on the table.
The drafting move at the LOI
The drafting move that protects the founder is short and inelegant: insert a sentence into the LOI that says the management incentive pool, in whatever form NewCo establishes one, shall dilute the sponsor’s equity and not the rollover equity, and that the founder’s ownership percentage stated in the LOI is post-MIP. That sentence is sometimes accepted on the first redline. Sometimes the sponsor pushes back and proposes a compromise — for example, a pool that dilutes the sponsor and the rollover holders pro rata, which is a worse outcome for the founder than full sponsor dilution but a better outcome than full rollover dilution.
The compromise that sponsors propose most often is to give the founder a grant out of the MIP on closing day equal to a percentage of the pool. The grant has real economic value, but it is profits-interest in nature and it sits behind the sponsor’s preferred return, which means it has less value at the deal close than the common rollover equity it is being offered to replace. A founder who accepts the compromise without modeling the difference is trading down on a basis that is not visible in the LOI math. The same modeling discipline applies to the Section 280G parachute haircut that hits founder change-in-control payments.
The other drafting move is on the timing. Some sponsors structure the MIP so that the pool is reserved but not granted at closing, and the dilution applies as grants are made. Under that structure the founder’s signing-day cap table looks clean and the dilution shows up as grants happen over the following twelve to eighteen months. The founder should not be reassured by the clean signing-day cap table. The dilution is coming. The founder should negotiate the pool size and the allocation method on the basis of the fully-reserved capitalization, not the as-granted capitalization.
What to ask before signing the LOI
The questions are three. First, what is the size of the management incentive pool that NewCo will establish at closing, expressed as a percentage of fully-diluted equity? Second, will the pool be allocated pre-rollover or post-rollover — that is, will the founder’s stated ownership percentage be net of the pool, or gross of the pool? Third, what is the form of the equity in the pool — profits interest, restricted common, options — and what is the participation threshold?
The sponsor’s deal team has answers to all three. The questions are not exotic and the answers are not confidential. A sponsor that resists giving the answers at the LOI stage is telling you something about how the rest of the negotiation will run. A sponsor that gives the answers cleanly is telling you something different.
The broader point is that the LOI is the moment where the founder’s leverage on this term is at its peak. The deal has not closed; the sponsor has not yet committed to the price; the founder can still walk. By the time the stockholders agreement is on the table the sponsor has spent legal fees, the founder has answered diligence, and the cost of breaking the deal over a pool-allocation question is asymmetric. The economics of the M&A negotiation move sharply against the founder once the LOI is signed. The MIP is one of the terms that moves the most.
The honest summary on management equity pool dilution
The top-up management equity pool is not a trick. It is a standard PE deal architecture that exists for legitimate reasons and that the sponsor will set up on every deal it does. The trick — if there is one — is that the pool’s existence and the pool’s allocation method almost never appear in the LOI, and the founder who does not ask is the founder who finds out at the first board meeting that his rollover percentage is three to four points lower than the number he carried in his head.
The drafting fix is a one-sentence LOI provision. The economic fix is to model the post-MIP rollover percentage at the LOI stage and to negotiate the deal economics against the modeled number, not against the gross number. The negotiation is winnable. It just has to happen at the right time.
If you are a founder looking at an LOI from a PE sponsor and want a second read on how the post-closing capitalization will actually allocate, feel free to reach out to my firm manager, Magda, at Magda@montague.law, or fill out our contact form. Mention you read this post.
