One of a business’s most valuable assets is its people. The single most important factor giving rise to a company’s higher value, other than increasing cash flow, is the existence of a stable, motivated management team that will remain in place after the owner exits.
Yet in many transitions, owners don’t address the future of their employees in time to maximize value. In many cases, because of a failure to plan and anticipate, key employees become fearful of looming changes, and the company experiences reduced productivity and cash flow, a loss of good talent, or possibly sabotage – and all directly reduce a business’ sale price.
Putting the right employment incentives and agreements in place will help ease employees’ worried minds, protect the company’s assets, and increase the value of the business.
The scenario: Frightened key employees quit and compete
Consider a baby-boomer business owner who wants to transition into retirement, and enters into discussions with a buyer. The buyer begins its due diligence, reviewing the company’s financials, customer contracts and relationships, etc. The prospective buyer’s goal is to purchase a good business and make it even more profitable.
Key employees Alex, Brenda and Claudio become frightened for the future of their jobs. They inevitably distrust the buyer and don’t see what’s in this sale for them. Alex, Brenda and Claudio have the direct customer relationships, and Claudio holds the necessary state licenses to engage in business in the industry. The three key employees leave the company and start a competing business, leading to an immediate revenue loss of $50,000 per month. Amid the turmoil, the potential buyer walks away.
The unprepared owner is left not only with a botched sale, but also too few key employees to continue running the business, reduced market value, a lack of adequate licensing, and a new competitor that will make regaining market value difficult.
Plan ahead with precautionary and incentive agreements
While most employees fear change, they also realize change is inevitable. The smart owner can maximize the value of the business by ensuring that key employees are prohibited from competing and are incentivized in the short run to see the company through a profitable sale and years of smooth operation under the new owner.
Many companies experience a direct increase in value if key employees and those with crucial client relationships are bound by an agreement that restricts what employees can do with the company’s proprietary information and relationships. Owners will want to bind key employees to noncompete agreements. Sales employees and others with key client relationships should be bound, at least, by nonsolicitation agreements to prevent them from moving to a competitor and calling on the company’s customers. And all employees should be bound by nondisclosure agreements that require employees to keep the company’s secrets confidential.
Restrictive agreements are highly regulated by state laws. An attorney is needed to evaluate the enforceability and assignability of existing agreements and a company’s options if no agreements are in place.
Bonus retention and/or severance agreements
Unlike with long-term incentive programs, key employees may be comforted if they are promised financial gain in exchange for effectively transitioning operations to a buyer. These agreements typically motivate a key employee to: 1, maintain or increase the company’s income stream in the years leading up to a sale; 2, ensure a smooth due diligence process; and 3, provide successful management and operations after a change in control.
There are many ways to draft short-term incentive plans to meet these goals, like a bonus plan, retention or stay plan, or other golden handcuff plans. By way of example, a company could create an escrow account. When the sale closes, a percentage of the sale price is deposited into the account, with a small percentage vesting immediately and then greater percentages vesting each year for three years.
The first vested payment from the account, made at closing, would be large enough that the key employees would feel fully rewarded for their hard work preparing the company for sale, but not so large that they choose to follow the owner out the door. The annual payments thereafter are paid provided the employee remains with the buyer. Any money left in the account at the end of three years reverts to the owner.
With an agreement like this, the key employees are encouraged to build maximum value in the company in the years leading up to a sale so that a larger amount of money is placed into the account. If they are not hired by the buyer, they still receive their first vested payment, which is large enough to make them feel compensated for their hard work. If they are retained by the buyer, they are motivated to continue working hard to maintain and increase cash flow because if they remain employed by the buyer, they receive additional cash from the account.
There are many other examples of short-term bonus plans that can achieve an owner’s goal to maximize, capture and keep the value of his or her business in a sale. Regardless of how the incentive plan is structured, it is essential to begin planning early.
Such agreements add value to the company in the buyer’s eyes because it ensures consistency in operations during a transition. The last thing a buyer wants is for the employees to jump ship just before or after the transaction closes. And perhaps one of the greatest advantages to an owner is the assurance that if a deal falls through, the key employees will still be around to operate the company until the next transition opportunity arises.
Amanda Gamblin is a shareholder in the Portland office of Schwabe, Williamson & Wyatt and a member of its business transitions group. She focuses on employment law. Contact her at 503-796-2903 or [email protected]