5 Ways Key Employees Hijack Company Sale Value
Imagine that things are great with your business, revenues, margins and profits are all up — everything is running like a well oiled machine. So, you decide that the time is right to cash out and sell your company to the highest bidder.
Pretend it all goes well and you have several interested buyers who are all willing to give you your dream purchase price and more. So, you take the next step. You sign a letter of intent with the buyer and due diligence on your company begins.
All of a sudden you realize your top employees are really the key to get your deal closed and depending on your employee’s motivations and actions, your purchase price can go up and down or it may kill the deal altogether. We call these the key employee hostage scenarios.
First, there is the Contractual Scenario. There are two contractual aspects that can create a nightmare for you. These are non-compete and non-solicitation agreements. Non-competes are basically contracts between the employer and the employee that restricts the ability for the employee to compete with the employer for a certain duration of time. This keeps your key employee from starting a new business right when you are in the process of selling your business. In non-solicit agreements the employee cannot solicit your company’s clients, as well as, solicit other employees for recruitment purposes.
We’ve seen cases where the employees have caused a lot of problems for the selling business owner, because the business owner did not have the right contracts in place with their key employees. Even if you have the best contracts, many states do not recognize non-compete agreements or there may be serious enforceability issues with these agreements. Therefore, it’s best to have these on your radar.
Next is the Last Minute Scenario. The very definition of a key employee is an employee who is essential to the livelihood of the business. Since this employee is a key employee, in some cases they have the capacity to go down the block and start their own business, especially with unenforceable or negligent contracts. Additionally, the employees may have the power to take some of your other other employees with them.
We came across a situation recently where the key employee, during due diligence, demanded that he be given a significant chunk of the sale proceeds or he would walk. The key employee was material enough to the business, so much so, that the buyer would not buy the business without the presence of that key employee. As a result, the business owner was held hostage and ended up having to share a nice chunk of change with the key employee to get him to stick around.
Next is the Respect Scenario. With this scenario, the business owner in a sale is extremely worried about confidentiality and almost never takes the time early on to tell the key employees that they’re intending to sell. Often there’s no clear plan for participation in the sale proceeds. As a result, the key employee may feel disrespected and may not stick around. If they leave during due diligence, the sale could fall apart. If the employee’s leave after you’ve sold, depending on the transaction structure, especially if you have an earn-out, it could still cost you an arm and a leg.
Next up, is the Burn-Out Scenario. Everyone always talks about the business owner burning out and that being a motivation to sell the business. What no one talks about is the key employees burning out. In many cases the key employee may not want to stick around for much longer because they’re burnt out and they want to start a new chapter in their life.On the other hand, the buyer may make their offer contingent upon the key employee staying and at the last minute you are scrambling to convince your key employee to stay, by giving them hefty incentives so you can get the agreed upon purchase price.
Finally, let’s talk about the Step Back in Scenario. This comes into play in an internal succession to family members or other key employees. To make the transition successful, you need your principle key employees to stick around, if they start leaving you may need to step back into the business to help your successors, especially if you have a vested financial interest.
To avoid being stuck in any of these unfortunate scenarios, we always advise our clients to lockdown their key employees through various incentives. You want your key employees to perform before the sale, leading up to the sale, during the sale and after the sale, during the earn out or other contingent period.
Consider “golden handcuffs” in the form of a deferred compensation plan or a sinking fund long before the sale is ever considered. Generally, we may also recommend that a certain percentage of the future sale proceeds be added to that sinking fund. As a part of making this plan work long-term, performance metrics and a vesting schedule are created so key employees have measurable targets and a vested interest to help sell the company and to keep the company performing post sale.
Remember, the buyer is not just buying your cash flow, they are buying the stability and the sustainability of that cash flow. If the buyer feels that the cash flow is at risk, you will either get a valuation discount, resulting in less money in your pocket, or they will simply walk away from your business. Most business owners agree that their key employees are their biggest asset. If your biggest asset goes home tonight and refuses to come back tomorrow, I’m sure you understand the consequence of that action on the value of your business.
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