As discussed in the last email, when the owner contemplates selling their company, one of the important aspects is communicating the news to the management team. When should the owner tell them about the deal? Who should the owner bring into their confidence? How should they be incentivized to work with the owner to complete the transaction? It is a lot to think about. And it can be stressful for an owner to coordinate all of the moving parts internally while working toward an exit.
We discussed how to handle the “when” and “who” to tell in our last email. In this email, we will take a closer look at incentives to help ensure that management is “on board” during the sale
It bears mentioning again that the sooner an owner informs management about the sale, the better and it is important to handle the news delicately. Waiting until sale discussions have progressed will likely not be well received by the senior leadership team.
In addition, management may be concerned about their job security. All parties are better served if management can come to terms sooner rather than later with the potential sale and understand how it could affect them both from an employment and financial perspective. Finally, it is important for management to be advocates, particularly since they will be integral to the due diligence process. Management buy-in can assure that due diligence will proceed smoothly and they will remain with the company during the sale process.
Owners can takes steps to assure continuity by having proactive discussions with key employees, even during the hiring process particularly if the owner is considering selling the company in the near future. In fact, the owner might be hiring certain employees specifically to prepare the company for sale. In both cases, the early discussion of incentives creates transparency and addresses the employee’s future and financial security. In addition, the incentives promote employee retention since some of the incentives are designed to have value only if the employee remains with the company through to the liquidity event.
Considerations in designing employee incentives include: 1) is the incentive intended to be purely economic or is the owner comfortable with the employee becoming a “partner”, 2) which form of incentive would be most highly valued by the employee, and 3) how will the incentives be taxed, i.e., as ordinary income/short term capital gain or long-term capital gain. Pro-active efforts can optimize the tax outcome for the employee and make the incentives more valuable to the employee.
Options for compensating employees include 1) a deal bonus to assist in bringing the transaction to a successful close and 2) compensation that is tied to the sale value or equity value creation during the term of the employee’s employment.
In the case of the former, the owner can offer the employee an $x bonus payable at the closing of the transaction. The bonus should align with the sale value, the employee’s role in helping to close the transaction, and may include an element related to the tenure of the employee’s service to the company. The drawbacks to a bonus include: 1) the owner controls whether or not the deal closes and the employee may work hard and not receive the bonus if the deal does not close through no fault of their own and 2) the bonus is tax inefficient since it would be taxed at the prevailing ordinary income tax rates.
In the case of the latter, incentives can be based on the increase in the equity value that the employee helped to create during the term of their employment. Examples include 1) stock options with the exercise price set at the current price per share, 2) profits interests or phantom stock both of which have a zero value at the time of the grant, or 3) the sale of common stock to the employee at the current fair market value of the company. In each case, the final amount of the incentive is correlated to the employee’s efforts. The main consideration is tax planning to assure that the value to the employee is maximized. As with the sale bonus, the employee cannot control the timing/certainty of receiving the incentive payment.
A critical part of an owner’s exit planning is to assure that key employees are well compensated for their contribution to building value and unlocking value. Selling a business is stressful for the owner.
Incentivizing the senior leaders to be advocates for the transaction can help to ensure a smoother transition and a more efficient exit. It is money well spent!
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