Key Employees – What to Know Before Selling your Business

You may be thinking of selling your business. You might have back-of-the-envelope valuations, identified potential buyers, or even contacted a broker to help with the process. As would-be sellers get deeper into the process, however, they often discover they’ve overlooked several strategic planning issues.  One of those often overlooked issues is Whether and How to Retain Key Employees to Command Maximum Value. Overlooking this can lead to a host of headaches, ranging from delays, increased expenses, diminution of purchase price, to even the cratering of the deal. 

Who are ‘Key Employees’? 

While you may or may not consider certain staff “Key,” the exercise here is to anticipate who a likely buyer of your business considers critical to its successful transition to new ownership. Certain employees may not be ‘irreplaceable’, but without them, the transition to the new ownership would be significantly compromised. Senior executives are often (not always) KEs, so might certain managers, team leads, and other employees who are indispensable due to their experience, institutional knowledge, relationships with key customers or ongoing critical projects.  The degree to which KEs impact your deal depends on several factors, including:

  • What type of buyer is it?  “Strategics” - often competitors – typically know the business already, have the personnel, and look for cost synergies in staff, so they take a narrow view of key employees. “Financial” buyers, such as a private equity group or high net worth individual have greater dependencies and expect more management continuity.
  • What’s the composition of your customer base? Recurring, predictable revenue stream, or more isolated sales? Do you have long service/production cycles (from order to delivery)? How much customer concentration do you have?
  • What does your sales cycle look like? Long and high-touch, or short and hands-off?  How much is in your pipeline and how vulnerable is it to disruption?

An experienced transaction attorney, broker or consultant can lead clients through this internal analysis, lending the perspective of a would-be buyer in the critical planning stages. 

Retention Strategies; Types of “Stay” Agreements

If a buyer determines that your bottom line is heavily dependent upon one or more “key employees” smoothly transitioning their functions, then they’ll need some assurances that the KEs will continue to serve the new ownership on reasonable terms (i.e. not “holding out” for better pay or benefits). From a planning perspective, the Seller can typically obtain such assurances in advance, and in a way that’s a “win-win-win”. In Advance being the operative phrase – early planning is critical. 

There are several flavors of “stay” agreements, each with various Pros and Cons that require some careful consideration of the particular “facts on the ground.” The first and perhaps most important consideration - before you throw a retention package at Chris the controller or Sarah the sales exec is: Are they really at risk of leaving?  It’s important to understand a) the motivations of your key employees and b) the competitive landscape before deciding whether & how to approach them with a “stay” offer. What makes them tick? How much are they motivated by money vs. recognition, new challenges, and other non-monetary factors? How long have they been with the company? How far along are they in their careers? Do they have any equity or profit sharing in the company? How are you currently compensating them relative-to-market? What is the going-demand for their services in the marketplace? We'll discuss just a few...

Stock or Unit Options. Options are a versatile tool for retaining and incenting employees. More commonly, they are offered to all eligible employees, but the number granted varies according to their (expected) level of contribution to performance. They can be an effective tool to help get you to the transaction finish line, but don’t provide any greater incentive for the KEs to stay on with the new buyer. From a tax standpoint they are generally efficient, not creating a tax liability unless/until the employee exercises, and then they are an expense for the company.

Employee Retention Agreement. This agreements is typically a promise that the employee will receive their same compensation (or more) and benefits through a certain period of time (e.g. one year), and if they are terminated earlier other than for "cause", either by Seller or the new buyer, they will receive separation pay equal to that.  Often there is also a guaranteed retention bonus if they stay for the specified period. These create incentive to stay through and after closing, but the Seller may be asked to shoulder some of the cost in the form of purchase price adjustments. 

Phantom Stock Agreement. This is essentially an employee bonus that’s contingent upon a sale or similar transaction happening while they are still there, the amount of which is based on a percentage of the total transaction value. For example, a KE may have a “phantom equity” deal where they will receive 1% of the sale proceeds. It provides both an incentive to stay and perform through the transaction, but typically after too.  However, a seller may be asked to help shoulder the cost of this. 

Other Considerations

Non-Solicitation and Non-Compete Agreements. If you're going to offer employees special retention terms, you should consider requiring them to sign a non-solicitation and/or limited non-compete agreement as part of the agreement for them to stay. To make these clauses enforceable post-employment, some consideration needs to be offered in exchange for their promise to non-compete or solicit. In 2004, the Washington Supreme Court held that a non-compete agreement entered into after employment has commenced is validly formed only when there is independent consideration at the time the agreement is reached. Labriola v. Pollard Group Inc. 152, Wn.2d 828, __P.3d__, (2004). Thus, if a key employee has not already signed a non-solicitation or non-compete agreement, it is crucial to couple these agreements with some sort of compensation arrangement to ensure there is adequate consideration. 

How and When to tell your Key Employees about the Deal? Timing is key. Mishandling communication can create uncertainty among employees and cause key employees to leave out of fear of losing their job. This too is a decision that warrants careful thought and consulting with experienced transaction advisors. In our experience, it is better to err on the side of disclosing - with adequate protections in place - early, at least to your key employees that will be involved in the process (i.e. helping to prepare and respond to due diligence inquiries). This approach creates a team mentality and loops key management into the sale process. However, doing so creates a risk the information of an impending sale will be leaked to all employees, or the customers, suppliers or competitors. Thus, you will need to balance the need to keep your key management apprised of the sale with the risk associated with disseminating information too soon in the process. 

“Appreciation Bonuses” We caution owners not to offer “appreciation bonuses” to their employees. While a selfless, honorable gesture, they often have negative and unintended consequences:

  • Suboptimal tax consequences to the employees and/or the seller
  • Employer/Seller “loses” the opportunity to secure valuable services from the employee (i.e. the incentive to stay and perform to optimize the sale price, and to agree not to compete or solicit (something the seller might not care about, but the buyer values).
  • May actually create a disincentive to stay; buyers often perceive these as “vacation funds”, where the employees “check out” for a while after the closing. 

In short, it is much preferred that the seller implement a thoughtful retention agreement strategy rather simply a discretionary show of thanks.

DISCLAIMER: The information contained in this blog is not intended as legal advice for you. It is intended only to provide general information, and to promote self-analysis, more informed questions, and further discussion with advisors. Specific legal problems necessitate specific legal advice tailored to each client’s specific set of circumstances. Use of this Blog does not create an Attorney-Client relationship.