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Management should be protected during an M&A transaction

How CEOs and Management Teams Can Be Rewarded and Protected in an M&A Transaction

Finance

Mergers and acquisitions (M&A) of private companies are complicated, time-consuming, and stressful. The CEO and management team of the seller are essential to the success of a potential deal. This article explores the potential executive compensation arrangements and protections that are beneficial to the management team and the selling company,

These observations are based on my having been involved in over 200 M&A deals over the years with the likes of Google, eBay, Boeing, Fox (News Corp.), Qualcomm, NBC, LexisNexis, Dun & Bradstreet, Nokia, Sony, private equity firms, Silicon Valley emerging tech businesses, and other companies.

Complicated Issues Faced by CEOs and Management Teams

CEOs and management teams face a number of challenges in trying to navigate to a successful closing of an M&A deal, including:

• Creation of pitch decks and confidential information memorandums
• Creation of an online data room containing complete corporate documents, contracts, intellectual property information, employee information, financials and much more
• Preparing for management presentations to, and responding to myriad meeting requests from, potential buyers
• Responding to all encompassing due diligence requests from potential buyers
• Preparing disclosure schedules for the M&A agreement (which can take up to 15 drafts and 50 pages to get right)
• Coordinating efforts with investment bankers and legal counsel
• Preparing and defending financial projections and related assumptions
• Negotiating the terms of any letter of intent and the definitive M&A agreement with the assistance of legal counsel
• Managing employee morale and concerns that in working for the acquisition, they may be, in essence, working themselves out of a job
• All of the above while simultaneously running their day jobs and ensuring that the business doesn't suffer from the distractions

Those are some of the reasons why it's important that CEOs, management teams, and employees feel like they are being appropriately rewarded and protected. Let us explore some ways to do that.

Change in Control Transaction Bonus

It is appropriate and reasonable for the CEO and management team to request a "change in control" transaction bonus contingent on the closing of an M&A sale. Sometimes these are referred to as “management carveouts.” Here are some key elements of this type of bonus plan that will need to be decided:

• Amount of bonus. Bonus amounts for the CEO, management team, and employees can range from an aggregate of 6% to 10% of the gross sales price. (See the SRS Acquiom 2024 M&A Deal Terms Study). This can vary depending on the size of the M&A transaction.
• When paid. At the closing of the M&A event.
• How split among the employees. This varies but usually takes into account seniority level, compensation level, and time employed by the company. The CEO’s bonus would typically be in the range of 2% to 4% of the sale price, depending on the size of the bonus pool and other factors.
• Obligations of employees. Typically asked to sign a release form at time of payment, although the employee will ask for a mutual release. Employees typically must remain employed through closing in order to be eligible to be paid.
• Stock options. The change in control bonus is typically in addition to any stock option value held by the employee, especially if the options are underwater.

Treatment of Existing Stock Options in an M&A Event

Management will be mindful of how their existing stock options or equity incentive arrangements will be treated in an M&A event (assuming they exist and are not underwater).

• Accelerated vesting. To the extent any employee stock options are not fully vested at the closing of the M&A event, management often requests that all or a portion of the unvested options become accelerated vested. Buyers typically seek cancellation of underwater or unvested options.
• Cashless exercise. The option holder will want to "cashless exercise" their options, negating the potential requirement that they put up cash to exercise.
• Interplay of options and change in control bonus amounts. The Board should be mindful to treat employees fairly and mindful of how the change in control bonus and stock options interplay. The lower the value of the options, the higher the change in control bonus should be.
• Escrow. If there is an indemnification escrow in the M&A agreement, will option holders be required to contribute to the escrow?
• Assumption of options by buyer. Will the buyer assume the options or decline to assume them and replace them with a different plan?

Severance Arrangements

Management teams and employees will naturally be concerned with losing their job in an M&A event. Either the seller or the buyer can implement severance arrangements that will mitigate those concerns. Analysis should be undertaken of any existing severance policies of the company. The idea here is that the severance arrangements would be in addition to the change in control bonus.

• Amount of severance for CEO. If the CEO is fired without cause or quits for good reason, it's reasonable for the CEO to request severance payments equal to 1-2 years of base pay, pro-rata accrued bonus for the current year, and 1-2 years of target bonus, plus continuing health benefits for that period.
• Amount of severance for other senior management. For other senior management where the executive is fired without cause or quits for good reason, it's reasonable to request 6 months to 1 year of base salary, pro-rata accrued bonus for the current year, and 6 months to 1 year of target bonus, plus continuing health benefits for that period.
• Amount of severance for rank and file employees. This varies across companies but is usually tied to compensation level, target bonus, and length of employment.
• Lump sum payment. It's best for the employee to receive a lump sum payment on termination and not one spread out over time.
• Important definition of cause. Since severance is usually only paid when someone is terminated without "cause," it's extremely important to the employee that the term is narrowly defined.

For a more in-depth discussion of severance packages, see my article: Severance Pay and Severance Agreements: What You Need to Know

Liability Protection

It will usually be appropriate and reasonable to the CEO and management team to have in place liability protections such as D&O insurance, Indemnification Agreements, corporate charter protections, and corporate bylaw indemnification. These are discussed below under "Liability Protection for the Executive."

Management Should Have Its Own Legal Counsel

It is appropriate and reasonable for CEOs and management teams to be represented by separate legal counsel, paid for by the company. There are many legal, liability, tax, and employment issues that experienced employment/benefits counsel can help with. These include how tax consequences can be minimized, how IRS Section 280G golden parachute issues can be handled, and the drafting of appropriate contractual rights for the management team.

New Employment Agreements With the Buyer

If the buyer wants to retain the CEO and the management team, it will usually be best for the parties to enter into new employment agreements or offer letters superseding the old ones.

There are a myriad of important issues in negotiating a favorable employment agreement for a CEO or for high-level executives, but experienced employment counsel can draft a fair protective agreement for the executive. Here are some of the key issues:

1. Scope of employment provisions. The scope of the employment and responsibilities raise a number of issues:

• What is the title of the executive’s job?
• Who will the executive report to?
• What are the executive’s responsibilities?
• Can the executive be demoted? Can the executive’s responsibilities be substantially modified, decreased, or increased?
• Is the executive guaranteed a seat on the Board of Directors while an executive? (Typically, this only applies to the CEO.)
• Where is the place of employment?
• Can the executive be relocated unilaterally to another city more than 25 miles away, or only with the executive’s consent?
• Is the executive allowed to be involved in other activities (e.g., a directorship on other Boards, involvement in community activities or non-profits)?

2. Compensation. Compensation is the most obvious key issue, but there are multiple layers of negotiating points encompassed here, including:

• Does the base salary increase each year of the contract?
• Is there a signing bonus?
• What quarterly or annual bonus is available? Is the bonus guaranteed, dependent on achievement of agreed-upon milestones, or wholly discretionary with the Board of Directors? Bonuses tied to budgets are common.
• Under what circumstances can the employee’s base salary be reduced, if ever?
• What benefits will be included (health, disability, dental, 401(k), vision, PTO, life insurance, etc.)?

3. Equity/option grants. Equity/option grants are often an important part of the Employment Agreement, and key issues here include:

• Should the grant be tax advantaged incentive stock options, non-qualified stock options, stock appreciation rights, or restricted stock units?
• If stock options, what is the exercise price? The executive will want the lowest price possible, which should be supported by an IRS 409A valuation.
• What is the vesting period for the equity grant? A typical scenario is four-year vesting with a one-year “cliff vest,” meaning the employee must be employed at least one year before anything becomes vested. Credit for vesting is sometimes given for prior employment served.
• What percentage of equity grant is appropriate?
• If the employee is terminated without cause, does some portion of the equity grant get accelerated vesting?
• How long does the employee have to exercise options after termination of employment? The typical period is 90 days, but this can vary depending on whether the termination is for cause, not for cause, or voluntary quitting by the employee to accept another job.
• Is there any acceleration of options upon an acquisition of the company? Does it require an acquisition plus a termination of the employee’s employment (a so-called “double trigger”)?
• Are the shares obtained upon exercise of an option subject to repurchase on termination of employment? If so, at what price?
• Are the shares obtained upon exercise of an option subject to a right of first refusal? If so, on what terms?

4. Liability protection for the executive. The executive may want to negotiate certain liability protection mechanisms, covering the executive performing services within the scope of employment:

• Will the company have Directors’ and Officers’ (“D&O”) insurance coverage?
• Will the company bylaws provide for indemnification protection for officers and executives?
• Will the company’s corporate charter limit the liability of officers and directors to the maximum extent permitted by law?
• Will there be an indemnification agreement that protects the executive, covering indemnification for claims, advancement of legal expenses, and protection even if the executive is no longer employed by the company (subject to some legal limitations on indemnification)

5. Term and termination issues. The circumstances in which the executive’s employment can be terminated and the resulting consequences will raise the following issues:

• How long is the employment term or is the employment “at will”?
• What are the grounds on which the company can terminate the executive?
• What are the circumstances in which the executive can be fired “for cause,” and how is “cause” defined? It is in the executive’s best interest to have a narrow definition of “cause,” such as (i) conviction of a felony or act constituting moral turpitude or (ii) material breach of the employment agreement after an opportunity to cure has been given (if curable).
• Is the executive entitled to severance pay on termination without cause? How much? Is it a lump sum or payable over time?
• If terminated without cause, is the company required to continue paying for health benefits or COBRA benefits for some period of time?
• May the executive terminate his or her employment (and receive severance payments) for “good reason,” such as change in responsibilities, compensation, or location of employment?
• If the executive is to receive a severance payment, the executive will typically be required to sign a release of liability for the benefit of the company, but the executive will want to negotiate this to be a mutual release.
• Will the executive be bound by a non-disparagement provision following termination of employment? If so, the executive will want to negotiate a mutual non-disparagement provision.

6. Confidentiality and invention assignment provisions. The employment agreement will have a number of confidentiality obligations of the executive, with appropriate carveouts. And the company will have agreements stating that any inventions invented by the executive within the scope of employment are the company's property.

7. Covenant not to compete. Some employers include a provision in the employment agreement that after termination of employment, the executive may not work for a competing business for a period of time. Executives typically resist this, as it suspends their ability to earn a livelihood. The executive will argue that the company is still protected even if the executive joins a competing company because of the confidentiality obligations of the employment agreement. In some jurisdictions like California, non-competes like this are unenforceable. If the company is insistent on a non-compete, then here are some steps to mitigate the risk to the executive:

• The term "competing business" should be narrowly drafted and not ambiguous, perhaps listing only a handful of named actual competitors.
• The period of the non-compete should be no longer than 6 months to a year.
• The non-compete should not apply if the executive is terminated without cause or quits for good reason.

8. Dispute resolution. Most employment agreements have provisions dealing with disputes between the company and the executive:

• How are disputes resolved?
• Should confidential binding arbitration be the exclusive way to resolve disputes? (This is my preferred mechanism from the executive’s standpoint.)
• In what city must disputes be brought if litigated or arbitrated?
• What is the governing law?

9. Reimbursement of legal expenses. It is common for the executive to request reimbursement of the executive's reasonable legal expenses incurred in negotiating the employment agreement.

10. Private equity firm buyer issues. If the buyer is a private equity firm instead of a strategic buyer, additional issues regarding equity ownership and rollover will need to be addressed.

For more analysis of negotiating employment agreements, see my article 14 Key Issues in Negotiating Employment Agreements.

Retention Agreements

Retention agreements are also sometimes used in M&A deals. Retention agreements are contracts between a buyer and key employees of the seller, providing them with financial inducements to stay with the company post-closing of the M&A deal.

• Purpose: To ensure a smooth transition and to retain critical knowledge, customer relationships, tech expertise, and skills important to the continuing business.
• How structured: Typically as a bonus payment made after continued employment for 6 months to two years. Can either be a set dollar amount or some percentage of salary.
• Which employees receive them: Primarily senior management, key tech personnel, and employees with important client relationships.
• Benefits to buyers: Minimizes disruptions in operations and protects IP and other important assets of the seller.
• The terms are key: For the employee, the terms (amount of bonus pay, obligations, time period to obtain the bonus, conditions to receiving the bonus, any non-competes, etc.) are key. Retention agreement terms are negotiable.
• Interplay with employment agreement: If the employee is to receive a separate employment agreement, the retention bonus can be incorporated into the employment agreement with no need for a separate retention agreement.

Employee Provisions in the Acquisition Letter of Intent

Buyers and sellers frequently enter into a letter of intent for sale of the business to lay the framework for a deal. It can be very helpful for the management team and employees to build into the letter of intent some of the compensation, incentive arrangements, and protections discussed in this article. This can help avoid misunderstandings later in the M&A process and preserve morale.

Bonus in the Event an M&A Deal Falls Through

M&A deals fall apart all the time through no fault of the management team. Given the significant efforts put in by management teams in M&A processes, it may be appropriate for the Board to award compensation to key executives even if a deal does not close.

Conclusion

It is important for the CEO and the management team to be incentivized, rewarded, and protected in the context of an M&A event. It's the right thing to do for the team, the employees, and the shareholders.

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Copyright (c) by Richard D. Harroch. All Rights Reserved.

Profile: Richard Harroch

Richard D. Harroch is a Senior Advisor to CEOs, management teams, and Boards of Directors. He is an expert on M&A, venture capital, startups, and business contracts. He was the Managing Director and Global Head of M&A at VantagePoint Capital Partners, a venture capital fund in the San Francisco area. His focus is on internet, digital media, AI and technology companies. He was the founder of several Internet companies. His articles have appeared online in Forbes, Fortune, MSN, Yahoo, Fox Business and AllBusiness.com. Richard is the author of several books on startups and entrepreneurship as well as the co-author of Poker for Dummies and a Wall Street Journal-bestselling book on small business. He is the co-author of a 1,500-page book published by Bloomberg on mergers and acquisitions of privately held companies. He was also a corporate and M&A partner at the international law firm of Orrick, Herrington & Sutcliffe. He has been involved in over 200 M&A transactions and 250 startup financings. He can be reached through LinkedIn.