Rewarding and Retaining Key Staff in Connection with a Business Sale: Blackmail or Justice?

Overview

Many Middle Market business owners will be in for a significant shock when the day to sell comes and they find that key employees and management are suddenly not on their side. I have referred to this in the past as “strange, if predictable, behaviors around large sums of money.” There are various ways to go wrong with key employees when selling a Middle Market business, and the intent of this chapter is to forewarn against them and provide some advice on how to avoid or mitigate them. This chapter may seem both overkill and overwrought, except to experienced mergers and acquisitions (M&A) dealmakers. The problems enumerated are not at all uncommon; in my experience, they occur with alarming frequency in Middle Market deals. Middle Market M&A practitioners are well-advised to raise the all-important question very early on in discussions with prospective sellers: What has been promised to whom and on what basis? Have any such promises been documented? Investment bankers and sellers who fail to address this issue risk working for months on a transaction that may falter or fail at the very last moment. Promises of compensation or a share in the proceeds from the sale of a business, made by a Middle Market owner to minority shareholders and/or key employees, constitute a sleeper issue that, if inadequately addressed, can prove disastrous. Offhand remarks made or not made by owners can prove no less disastrous if minority shareholders and/or key employees misinterpreted or imagined promises of greater compensation or greater shares in the proceeds pending the sale of the firm.

Washington, DC—March 2000 Promises, promises

It was a Friday morning. I should have been feeling pretty good: The week was almost over, I had a Saturday tee time, and we were enjoying the first decent, if early, golfing weather of the year. I was determined to play as much as I could that season, to knock a few more strokes off my embarrassingly high handicap.

But my stomach was sinking as my partner told me that it looks like months of very hard work on a $50-million business might have proved to be a dry well, at least for the time being. It is particularly painful when these dry wells happen for all the wrong reasons, and this was the second time this year that we had run into the same problem and for the same wrong reasons. The owner had made some promises, at least allegedly, to a senior executive and minority partner, perhaps more or less vaguely, that she would share in some way and “be taken care of” when it came time to sell the business, with an amount higher than her actual legal ownership would give her the right to claim.

My thoughts ran very quickly into a stream of questions. When did this happen? Where did it happen? Was it at some office Christmas party, after too much holiday cheer and eggnog? Who knows?

Two imploding deals in one year—one on the East Coast, one on the West, for almost identical reasons, one with a senior executive, the other with a minority partner—made it even worse.

Admittedly, in each case the complainant actually was running the business, or a big part of it. Each had been relatively indispensable in creating the enterprise that was to be sold. The East Coast deal’s senior executive, a woman who clearly had been instrumental in building the business, was no less certain to play a major role in transitioning the business to the new buyer. Yet she was balking just short of the finish line for the deal. She was claiming she had been promised, albeit not in writing, a bigger stake in the sale proceeds than she now appeared poised to receive. The West Coast deal had been on the verge of foundering because an influential executive, who also was a minority partner himself, was claiming to have been promised an additional share of sale proceeds, once again without anything committed to paper.

I asked my partner Mike, what he thought. “How the hell would I know?” he answered, unhelpfully. I understood his frustration all too well, having found myself no less confounded, and no less irascible, when on both coasts the disputants seemed to be claiming something they were not (at least apparently legally) entitled to. And it was impossible to know what the facts were, and where, how, and by whom those facts had been misinterpreted or maybe even distorted. Assumptions get made, even over the sketchiest of remarks, and then they become set in the concrete of selective recollections. Months or years later, these recollections resurface as a deal is about to be done, when the business is about to be sold. Seasoned investment bankers will tell you this happens time and time again.

Not-insubstantial settlements were necessary to get these deals done . . . but they did get done. This time anyway.

Key Employee Rewards in General

Entire books have been written about the intricacies of rewarding key employees. Potential rewards run the gamut from stock options and other ownership plans, bonus arrangements, stay bonuses, phantom stock option plans, and numerous variants thereof. This chapter will not address the many permutations by which key employees may be compensated. Rather, it will focus on five basic issues that must be addressed from the point of view of a sale of a business:

• The need to arrange to retain key personnel to a point sometime after the sale

• The need to arrange for nonintervention and/or noncompete agreements with key personnel

• The need to arrange stay bonuses, timing them properly, and avoiding overpaying them

• The need to arrange to document promises that might have been made earlier, and to avoid making vague promises

• The special problems of absentee owner, key employees, and key employee rewards

The Need to Reward Certain Key Employees

Rewarding key personnel is an important element of many Middle Market M&A transactions. While buyers may offer moderate signing bonuses to newly-acquired key employees in an M&A transaction, and/or include them in buyer stock option plans, the burden for both rewarding and retaining key the seller when selling a Middle Market company. Sharing sales proceeds with key employees often reflects altruism and a sense of fairness. Sellers often acknowledge the instrumental roles such employees have played in helping build the company. Beyond altruism, however, sellers recognize that their businesses will depend in large part on the continuing commitment of those key employees if they are to achieve a successful transition to new ownership. Thus, it is very much in the seller’s interests to establish incentives that encourage key employees to remain with the company through a transition period of from one to three years post-sale. A buyer’s biggest fear—and this point will bear occasional repeating throughout this book—is that it will settle on the purchase of a business on Friday, only to find itself the owner of an entirely different enterprise when it opens the doors for business on Monday. Among the biggest risks in this regard is that a critical mass of key employees will disappear between that Friday closing and the start of business Monday, at least figuratively.

Counterproductive Rewards

Whether rewarding key employees is altruistic, fair, or simply prudent business practice may remain a matter of debate, but sellers should consider very carefully the nature and size of such rewards, lest the rewards themselves prove to be counterproductive. Imagine a scenario under which a seller awards a key employee 10% of the proceeds from the sale of his $20 million business. The receipt of a $2 million windfall could tempt many employees into immediate retirement—particularly those in mid- to late-career who already have been investing for retirement for many years. A younger key employee, though he or she might be years or decades from retirement, could look upon a $2 million windfall as an invitation to pursue an entirely different career or to take an extended sabbatical from the workforce. Even if the seller is certain that financial incentives paid to key employees will not tempt those employees to leave the company, the buyer very likely will have serious misgivings. Occasionally, those concerns could make the buyer reluctant to acquire the business, especially when the seller intends an immediate exit from the business following the closing.

Timing Reward Payments

The timing of reward payments to key employees is therefore of critical importance. Ideally, the proceeds should vest in accordance with a schedule that encourages them to remain with the company for two to three years. In my experience, otherwise well-intentioned sellers overlook vesting consideration alternatives at least 50% of the time. Three principal elements should be incorporated within any agreement to reward key employees upon the sale of a company. In return for their incentive payments, those employees must:

• Agree to remain with the company for a specified transition period following the sale

• Agree not to compete with the company for a specified period following the sale and/or not to interfere (nonintervention agreements) with clients/customers and employees of the company in a manner detrimental to its interests

• Not be paid their key employee incentive rewards or bonuses until they have satisfied these and related requirements in full

Timing Tax Issues in Rewarding Key Employees

The timing and execution of legally binding key employee incentive agreements also may be of crucial importance due to capital gains holding period requirements. Inappropriate or ill-advised timing, or having the employees paid by the wrong party (whether that is the buyer or the seller) often may wipe out 25% or more of the benefit to the sellers, would-be recipients, or both, depending on the specific tax strategy. In the absence of written documentation, oral promises to pay such incentives are unlikely to stand up for tax purposes when it comes to establishing a date that can be used to determine whether such payments to key employees will be accorded long-term capital gains treatment or whether they qualify as capital gains at all. Sellers and their key employees should consult tax counsel to ensure that such plans reflect their mutual interests and tax considerations.

The Importance of Clarity and Documentation—Avoiding Vague Promises

When sellers make unspecified, undocumented, general promises to “share the rewards with” key employees, the “how much?” question inevitably arises and almost invariably creates real problems when the company is about to be sold. This problem is especially acute if noncompete and nonintervention agreements have not already been executed—or even if they have been, in cases where the employee’s presence in the continuing business is important. In any case, sellers and key employees often find themselves entertaining substantial differences of opinion when it comes to defining and interpreting how much will be shared when the business is sold. A lack of documentation compounds these issues, especially when a seller is likely to close a transaction in return for substantial financial proceeds. Key employees may feel cheated, while sellers feel blackmailed. Litigation may be and often is threatened or initiated. When buyers become aware of these problems, they are reluctant to proceed with the transaction. Would-be buyers understand all too well that potentially alienated key employees are less likely to prove effective in achieving a successful transition and continued operation of the business. In short, sellers should document all incentives for key employees in detail and in advance, so that these arrangements can have a sound legal basis and be clearly understood by both parties. Sellers also should construct and communicate the terms of such arrangements to prospective recipients well in advance of a sale of their business, to ensure that the key employees remain onboard and motivated throughout the transition period. Finally, allowing or encouraging a kind of unstated understanding of greater rewards to develop on the part of the key employee is serious mistake—and not an uncommon one, unfortunately.

When to Negotiate Noncompete and Nonintervention Agreements with Key Employees

Sellers should procure noncompete and/or nonintervention agreements from their key employees long before it becomes apparent that the business is for sale. Ideal points are when they are hired or when they receive a serious promotion or increase in compensation or responsibilities. In the absence of long term, in-advance-of-sale arrangements, nonintervention agreements may be more readily negotiable with key employees when combined with other devices or inducements, especially properly thought-out incentive and retention payments to be made in connection with the sale of the company.

Blackmail or Reasonable Compensation?

One man’s inducement may well be another man’s blackmail. If clarity and documentation of stay bonuses or shares of sales proceeds are not established well in advance, sellers may believe they are being forced, unfairly, to pay substantial sums of money to long-time employees (to whom they once entrusted the company and whom they are likely to feel they rewarded sufficiently for years) in the face of an implied threat by those same employees to launch a competing enterprise that will plunder the company’s own client lists and employment rosters or, more subtly, just fail to cooperate in the transfer of important relationships to the new owner/buyers.

Key employees, on the other hand, are likely to consider such arrangements to be justifiable and equitable. After all, in their minds, the seller is likely to reap substantial profits from the eventual sale of a company the key employees helped build. Furthermore, key employees may be quite right in arguing that the sellers’ wishing to restrict their own post-closing employment options must, and should, pay for the privilege. Meanwhile, seller and buyer alike will seek contractual assurances that key employees either remain with the company and/or decline to compete or interfere with it for a year or more following the closing of a sale.

Noncompete Agreements and Sellers

Some employees, of course, may also be sellers and significant owners, and while it may be somewhat of a non sequitur in this chapter, since we are discussing noncompete agreements, this is a good place to clarify the issue of noncompete agreements when it comes to owner/employees who are also sellers. For buyers, there is no getting around the critical importance of securing noncompete agreements from majority owner/sellers. The greater the financial consideration realized by sellers in the sales transaction, the more legally enforceable these noncompetes with them tend to be. Courts in general have ruled that a buyer is entitled to get what he or she paid for. In the case of key employees who are not owners, onerous noncompete agreements tend to be difficult to enforce as unreasonable violations of right-to-work principles.

Nonintervention Agreements

Nonintervention agreements are intended to protect sellers and buyers alike. Nonintervention agreements specifically prohibit sellers, minority owners, and/or key employees who execute them from interfering with the company’s existing customers, contracts, and/or employees. As I have already said, nonintervention agreements tend to be more enforceable and more effective against nonowner key employees than noncompetes, as they do not prevent future employment, just the pilfering of valuable relationships.

Being Alert to Potential Problems When Promises Made Are Not Consistent with the Duties and/or Influence of Key Employees

Even when a prospective seller carefully documents the benefits key employees will realize, complications may still arise on the eve of the settlement of the sale. When key employees believe the rewards they will realize are inadequate, given the sales proceeds, trouble may still result. Essentially, by definition, sellers will want to offer key employees financial rewards and inducements they believe to be completely appropriate and objectively fair. But if sellers and key employees cannot bridge any gaps separating their respective expectations, very little recourse short of litigation is available to them. In fact, the discontent of key employees at a critical point in the closing of a deal can implode that deal altogether, as buyers shy away from bad feelings, potential bad faith, and postclosing implications for their prospective acquisition. Key employees might become very vocal in their disagreement precisely because of the leverage they can wield in their own interests preclosing. That said, key employees should avoid acting in a manner so clearly intent upon queering the deal that they run the risk of being sued by the seller for tortious interference. Nevertheless, most sellers want to avoid litigation on the eve of the sale, and this does leave key employees a great deal of practical if not legal leeway. In some cases, key employees may impact the deal more subtly, but still materially, simply by resigning or at least threatening to resign.

A Way to Avoid Key Employee Problems in the First Place

Sellers’ intent upon minimizing the preclosing and posttransaction risks posed by key employees may pursue an entirely different course of action over time: develop a management team that is sufficiently broad and deep in experience and expertise that no individual employees are critical to the company’s continuing success. This may seem a tall order at first, but it is achievable. Sellers who can create a management team of sufficient strength to obviate the need for single key employees very likely will choose to incentivize that team following a sale of the company without having to pay out the sums that single key employees might demand.

The Special Problems of Absentee Owners

Experienced Middle Market M&A intermediaries and their sales-side clients should pay particular attention to key employee issues when the sellers have been absentee owners for some time. Sooner or later, many owners of successful Middle Market enterprises realize that they have established companies that can operate reasonably well without their full-time (or even part-time) attention. Some owners may step away from day-to-day operations long before an exit opportunity materializes or is desired. The success of such companies may reflect the ability of key employees to take over relationships with major clients or other important company staff while building new client relationships, altogether independent of the absentee owner. As the absentee owner loosens his grip on the reins, his connections to clients, vendors, managers, and employees gradually but steadily erode. Key employees’ psychic “ownership” in the company steadily increases.

Such transformations from owner to key employee dependence may be even more rapid and stark in companies where rapid technological changes force companies to accelerate product and service innovations or die. Absentee owners who become concerned and attempt to re-establish their dominance by asserting a tighter grip on the reins are more likely than not to exacerbate tensions with key employees, who will begin to take umbrage at efforts to interfere. “What does [the absentee owner] know anymore, anyway? The industry has changed and the business has changed with it. [The absentee owner] should just leave us alone to make him his money. He only shows up at dividend time these days, anyway.”

Under these circumstances, absentee owners’ efforts to sell their companies could be complicated by an all-out scramble to ensure that those on whom the company depends can be encouraged to remain with the firm through its sale and transition under new ownership. Even more so, their key employees—recognizing the extraordinary leverage they can exercise in advancing or imploding a deal—may try to exact significant concessions from the absentee owner/seller in return for allowing the deal to go forward and for promising to remain with the firm. Should the absentee owner/seller balk at financial incentives that key employees believe are commensurate with their contributions, entire executive staffs may rebel, one way or another, in full view of a prospective buyer or buyers. On such occasions, absentee owners might wish to consider selling the entire company—or at least a part of it—to the key employees themselves. A leveraged buyout or various gradual management buyout structures might be considered.

Absentee Owners ... Maybe the Best Advice to Consider ...

Alternatively, Middle Market business owners who realize that they are at eventual risk of becoming absentee owners should consider pursuing an exit strategy while they are on board and in charge of their enterprises. In fact, this is my usual advice to older clients who, having established successful businesses, are considering becoming absentee owners.

Wrap-Up

Key employees do not get to be key employees without making substantial contributions to the creation, development, and long-term success of the company of which they are a part. Sellers who are intent upon achieving a successful sale and a smooth transition will act cautiously and with great prudence to ensure that key employees receive adequate rewards that are documented fully and unambiguously, presented in a timely fashion, and which vest in alignment with noncompete, nonintervention agreements and desired transition stay periods.

Chapter Highlights

• Prospective sellers of Middle Market businesses should ensure that all exit strategy-related incentive and reward plans communicated with minority owners and key employees—whether informally or via formal agreements—are clarified, formally documented, revisited, and reaffirmed with those minority owners and key employees before launching the sale of the company, so as to avoid serious problems once a negotiated auction with buyers has begun.

• Bonuses and incentives payable to key employees in return for their remaining with the company through a postsale transition should vest gradually over the course of the entire transition period; immediate—or accelerated—vesting of such incentives may encourage key employees to jump ship on buyers prematurely, especially when the bonus is substantial.

• Sellers should secure noncompete and nonintervention agreements with key employees well in advance of the announcement of the imminent sale of their companies to encourage key employees to remain with the company through its sale and transition and to discourage them from departing the company to compete with the buyer.

• Noncompete agreements with sellers of Middle Market businesses are usually very enforceable, but may be less so with employees, where the agreements are too broad in scope.

• Absentee owners are particularly likely to face serious problems should key employees balk at their plans to sell the business and/or the financial inducements they propose to keep key employees onboard through a postsale transition under new ownership. The best ways to avoid such difficulties are: 1) Do not become absentee owners in the first place; 2) Seriously consider selling the firm before becoming an absentee owner; or 3) Seriously consider selling the company to an investor group led by key employees.