"Management contracts, retention bonuses and non-competes during the sale of a company"

by Dr. Jack Holder, Senior Vice President Efficient Evolutions LLC

Management Contracts

In many cases when an individual sells a business he will negotiate with the new owner for a “Management Contract” for a specific period of time.  Why is this necessary, or desirable?

The main reason is that it is important to keep the former owner around as he may be very instrumental to the continued success of the enterprise.  The company is “his baby”, started by him/her, nourished over many years, and the seller is often one of the primary ingredient of its success.  Most sellers are also concerned that the business will continue to do well under new owners.  They may be receiving negotiated “Earn-Outs” as a result of the financial results of the acquired enterprise.  The former owner may have a number of important client contacts that the new owner (s) will want to continue.  He may have technical knowledge that the new owners need to understand.  And the former owner will want to be assured that his loans are paid in a timely fashion by the new owners.  It is in his interest to see that the transition of the acquisition is successful.

There are many benefits to having a management contract with the former owner.  The contract can assure the new owners that the transition of ownership will proceed in an organized fashion, and will be successful. 

The acquisition may be a “preservation” acquisition (where the acquiring firm remains as a stand alone business) with the former owner continuing to play a key role in the management of the business.  Most small business acquisitions are “absorption” where the former business is rolled into the buying company, but the former owner will still be a key player in the successful integration of the two companies.  Good people are hard to find!

To a great extent, a management contract extension to employees, or management, will depend on the type of firm purchased.  If the purchase is a restaurant, the owner of the restaurant is literally “the restaurant” and the new owner must be sure that the management contract is in place.  In the case of absentee management, or an owner who is not involved with many key customers or have technical knowledge, the management contract may not be needed.  In a new acquisition in a small business, revenue and profit growth are extremely important and generally relationships with customers is key, thus the need for former employees or the former owner.  Also, in industries where good capable people are hard to find, the new owners may wish to assure their continuation for immediate business success.  On the other hand, the seller of the business may be at his retirement age and desire to “drive off into the sunset” to his Florida or Arizona home, and have no interest in continuing with the company after the transition is completed. Sellers should keep in mind though that few buyers will be willing to buy their firm if they are not willing to stay around for at least 3-6 months.

The age of the selling CEO may provide an interesting dilemma.  The business may have “passed him by”, he may not be close to customers, he may be a non-management owner, he may have very little knowledge of the business activity, or he may be very active and want to stay on in the business, etc.  The important thing is for the new owner to be fully aware of all of these relationships so that he can make the right decisions when making the acquisition. 

Retention Bonuses

Retention bonuses are one of the most efficient tools to assure that key employees do not walk away during the critical transition period. For example, the company may have a number of “key” technical employees who have knowledge generated in the business that could be harmful if they were employed by competing firms.  Some of these key employees could be very difficult, and time consuming, for the new owners to replace and their departure be harmful to the financial success of the new business.  In the case of a consulting firm, or technical firm where the employees play an important role (financial services, hydrological firms, etc.) and have key client contacts, they could take business with them if they left.  The new owners will want to preserve these “assets”.  I remember a case when a financial consulting firm was purchased, management contracts or retention bonuses were not put in place, and the human assets literally “walked out the door every evening”.   Because of a disagreement, they left in mass to form a new competing business and the acquiring firm had purchased very little. The names of key employees should be identified during the buyer’s due diligence and the offer of a retention bonus should be extended to them as soon as the employees are being informed about the pending sale. Retention bonuses usually range in size between 1 and 3 months of salary/wages and employees have to commit to stay for at least 6-12 months in order to qualify for the payout.

A seller should also consider paying key employees who will be exposed to the buyer during the buyer’s due diligence a small share of the sale price. Most employees fear change in ownership as it is perceived as a threat to their job security. They therefore have little incentive to help assure that the buyer’s due diligence goes smoothly. Some employees even deliberately “torpedo” the process thinking that it will protect their job. Offering key employees a share of the sale prices along with a retention bonus assures that they have an active interest in the transaction to close successfully.

Non-Competes 

A business seller most likely will also be asked to sign a “Non-Compete Agreement” specifying the geographic limitations on his ability to start a new competing business, and length of time for which the agreement will be in place. “Fair Market Value” actually assumes the presence of a non-compete agreement between buyer and seller which means most sellers will not be receiving additional compensation for signing a non-compete.

After the Purchase and Sale Agreement is fully executed the buyer owns the business and must live with reality, good or bad.  Efficient Evolutions LLC makes sure that their client, be he/she be the new owner or seller, fully understands and addresses each critical and important issue of the M&A transaction.   

The author would like to emphasize that the comments and examples in this article do not constitute advice for any specific action. The author strongly recommends that readers obtain counsel that is specific to their individual situation, before taking any actions.

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