What is sweet equity vs. strip equity and how do you negotiate it?
STRIP EQUITY — management invests proportionally with the sponsor across all equity layers (preferred + common). 1:1 ratio, no leverage. SWEET EQUITY — management invests disproportionately in common stock and (often) not at all in preferred / shareholder loans. Effect: management's share of the common is 5-15%, of total equity only ~3-7%, but with an outsized upside when returns are good.
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The sponsor puts $100m into preferred (10% PIK coupon) + $50m into common; management puts $5m into common and 0 into preferred. At exit after 5 years with $400m of common value: management receives $5m / $55m × $400m = $36m (7.3x MOIC on the sweet) — VS. a plain 1:1 strip would be $5 × ~3x = $15m. Negotiating levers:
- Hurdle rate — management only receives sweet equity AFTER the sponsor has reached its minimum IRR (typically an 8% hurdle)
- Catch-up — above the hurdle the sponsor receives 100%, then management 100%, until an 80/20 ratio is reached
- Vesting schedule — 4-5 years cliff/vesting
- Bad-leaver clauses — if terminated against the sponsor's will, management forfeits the unvested shares at cost, not at market price
- Tag-along and drag-along rights.
In the middle market, sweet-equity programs are typically 8-15% of the common for an investment of 1-3% of the equity — a perfect alignment tool.