Key Employee Issues in the M&A Process: Blackmailed or Cheated

Document Incentive, Retention, and Non-Compete Agreements; Build a Broad Management Team

Business owners need to be careful about vague assurances to “take care of” key employees before an acquisition. Brett Stacey offers tips on how best to manage a transition in a responsible manner that’s likely to address hurt feelings, protect employee morale, and minimize law suits.

At a holiday party, a successful business owner assured key employees that they “would be taken care of” if ever the company was sold. In fact, he went so far as to say up to 10% of any sale proceeds would be available to key employees if the company sold for the right price. The only part of that statement that the key employees heard was “10% of the sale proceeds.” Time went on and as fate would have it, the business owner wisely hired an investment banker and a deal to sell the company came to fruition. Only then did the key employee “promises” surface and threaten to scuttle the whole transaction. This situation is unfortunately quite common in middle market deals. The purpose of this article is to address various mistakes made by business owners in addressing key employee issues and to give some advice on how to avoid and mitigate these potential pitfalls.

Key Employee Leverage

Key employees of a middle market business have leverage when it comes time to sell. The value of the business is less without the key employees, and if they walk, the sale may not go through. After all, the buyer needs those key employees as much as the seller. Key employees get to be key employees by making significant contributions to the growth and success of the business and, usually, key employees are pretty smart. This leverage can be significantly mitigated with careful planning and preparation beforethe company goes to market.

Take care not to underestimate key employee leverage on the eve of the sale, particularly if it involves a large sum of money. Sometimes, even if rewards and payouts are well documented, key employees can simply get beside themselves. In these extreme cases, failure to reach a negotiated agreement leaves the parties with no alternative other than litigation. Buyers have little interest in litigation  bad feelings, and unhappy people associated with an acquisition. Hence, such a circumstance might crater the deal.

Clear and Concise Documentation

Making vague, undefined promises of being “taken care of” or “sharing in the proceeds” is a serious mistake. These discussions invariably focus on “how much,” and it’s not uncommon for a significant difference of opinion to arise. The best way to avoid this problem is by carefully and explicitly documenting any sharing understanding, or incentive rewards, before the company is even on the market.

Problem largely solved. Otherwise, once at the altar of closing day, those key employees may not be holding their peace.

Incentive and Retention Agreements

Buyers may offer modest signing bonuses or accelerated vesting in benefit plans, but it’s the seller’s job to deliver the key employees to the buyer as part of the intrinsic value of the business. Altruistically, rewarding key employees for past service is the right thing to do, but beyond altruism, the seller knows that a smooth transition to the buyer is dependent on retaining and motivating key employees to stay with the business from two to three years after the sale. 

A number of arrangements are available to retain key employees including employment agreements, stay bonuses, incentive bonuses, accelerated vesting, phantom stock and the like. Whatever the vehicle, the objective is to: 1) retain the key employees through the transition period, 2) secure cooperation during the due diligence process, 3) obtain non-compete and non-intervention agreements, 4) properly gauge the appropriate size and timing of any payments, and 5) clearly document promises made while not making any vague promises.

Incentive payments to retain key employees through the transition period must be timed or vested such that the majority of the payments come at the end of the performance period. Incentive agreements must address the transition period, the non-compete, and non-intervention provisions and be paid when these obligations have been met. Done properly, delayed payments might even qualify for capital gains treatment at tax time. Care must also be taken in the sizing of such payments. For example, 10% of the proceeds of a $40 million sale is $4 million, which could promptly bring on retirement for older employees at mid- or late- career. Moreover, the buyer may not be too thrilled about having a millionaire key employee that does not really need to work.

Non-Compete and Non-Intervention Agreements

Non-compete and non-intervention agreements with key employees should be obtained prior to embarking on a sale process—not the day before closing. Typically these agreements can be negotiated most easily when an employee receives a promotion, a greater scope of responsibilities, or a significant increase in compensation. If these agreements are negotiated with a sale imminent, the retention and incentive payments must be tied to the agreements. It is also a far more difficult undertaking when it’s done after the fact. Moreover, if these agreements are not established and clearly defined well in advance of a sale, a business owner may feel “blackmailed” into unfairly paying outrageous sums to key employees (likely well paid for a long time) over the threat of the key employees establishing a competing business,  pilfering customers and employees, or simply not cooperating in due diligence and an orderly transfer to a new owner. Key employees feel “cheated” because the seller is about to reap a substantial sum of money for a company they help to build. And if the buyer and seller want to restrict the key employees’ employment options, they should be obligated to pay for that restriction.

Buyers will insist emphatically on strongly worded non-compete agreements from the selling shareholders. The greater the price paid for the business, the more stringent the agreements. In a recent transaction, the buyer wanted non-compete agreements from all four selling shareholders even though three of the four were non–operating, outside investors in related businesses. The deal finally got done, but it took many hours of contentious negotiations on the non-compete language. While non-compete agreements from the selling shareholders are quite enforceable, the case is less so with key employees in that such agreements sometimes run afoul of right–to-work principles.

Non-intervention agreements, on the other hand, protect both the seller and the buyer and are enforceable against non-owner key employees. These agreements prohibit interfering with the company’s customers, employees, vendors, and contractual relationships. An individual may have a right to work, but not to steal valuable relationships from the company. 

The Best Solution

An even better way to stay out of key employee trouble is to build out a sufficiently broad and deep management team where no single employee is critical to the effective management of the business. Actually, buyers prefer well-rounded management teams and pay a premium for them; otherwise known as a positive value driver. This team will need to be rewarded and incentivized for all the reasons listed above, but quite often, it costs less to incentivize the team than it does a key employee; the latter having that all important leverage. 

Hapless Absentee Owners

Absentee owners face a particularly daunting situation with key employees, negotiating leverage on steroids. Once an owner steps away from the business, the grip on the reins slips as key employees take over customer relationships, build new relationships, and become increasingly independent of the absentee owner. In fast-paced industries experiencing rapid change, the absentee owner can become obsolete fairly quickly. In these situations, there is little chance the absentee owner can reassert any control. Expect key employees to extract maximum concessions. Perhaps the best solution for an absentee owner to maximize proceeds when faced with this circumstance is to sell the business to the employees as a management buyout. Actually, the best solution is not to become an absentee owner in the first place. When you’re ready to go, sell the business, and go.

Summary

In summary, key employees can have substantial negotiating leverage once a sale is announced or imminent. To mitigate that leverage, middle market business owners should carefully document incentive and reward plans, obtain non-compete and nonintervention agreements from key employees and periodically revisit these with key employees prior to any M&A sale process. Retention and incentive plans should be designed to retain key employees through a transition period and vest gradually over time with the bulk of the incentives back end weighted. Absentee owners can find themselves in a particularly bad situation and should give careful consideration to not becoming an absentee owner. With proper planning, key employee issues can be minimized and a successful and rewarding sale can close.

Brett Stacey, CMAP, is an Associate at Legacy Advisors.