Compensating Management

The success of Kleiner Perkins’ investment critically depends on its ability to execute the operational improvements laid out in its business plan. Kleiner Perkins has learned from experience that it is much more likely to achieve its goals if the management team responsible for implementing the changes is given a strong incentive to succeed. Kleiner Perkins therefore considers allocating 10% of Ideko’s equity to a management incentive plan. This equity stake would be vested over the next five years, and it would provide Ideko’s senior executives with a strong financial interest in the success of the venture.

We would therefore like to know what the cost is to Kleiner Perkins of providing this equity stake to the management team? Also we would like to know how such an incentive plan might affect the NPV of the acquisition.

To determine the value of the acquisition to Kleiner Perkins, we must include the cost of the 10% equity stake granted to management. Because the grant vests after five years, management will not receive any of the dividends paid by Ideko during that time. Instead, management will receive the equity in five years time, at which point we have estimated the value of Ideko’s equity to be $172 million (Ideko - Horizon Value Multiples). Thus, the cost of management’s stake in 20Y0 is equal to 10% * $172 million = $17.2 million according to our estimate. We must determine the present value of this amount today.

Because the payment to the managers is an equity claim, to compute its present value we must use an equity cost of capital. We take a Flow to Equity (FTE) valuation approach to estimate the cost of management’s share in Ideko, as shown below:


To compute Ideko’s equity cost of capital \(r_E\), we use the below equation, which applies when the debt levels of the firm follow a known schedule:

\[\begin{align*} r_E = r_U + {D - T^s \over E} * (r_U - r_D) \end{align*}\]

Using the debt, equity, and tax shield values from the spreadsheet (Ideko - APV Valuation) we compute the effective leverage ratio \((D - T^s)/E\), and from this, we then compute \(r_E\) each year as shown in the spreadsheet above.

We then compute the cost of management’s equity share by discounting at this rate:

\[\begin{align*} \text{Cost of Management's Share }_t = {\text{Cost of Management's Share }_{t + 1} \over {1 + r_E (t)}} \end{align*}\]

Once we have determined the cost of management’s equity share, we deduct it from the total value of Ideko’s equity (Ideko - APV Valuation) to determine the value of Kleiner Perkin’s share of Ideko’s equity, shown as the last line of the spreadsheet above.

Given the initial cost of the acquisition to Kleiner Perkins of $53 million, Kleiner Perkins’ NPV from the investment, including the cost of management’s compensation, is $103.58 million - $53 million = $50.58 million.