Addressing Key Employees

Many years ago I represented the owners of a business that was to be sold to a private equity firm.  As should be expected with an experienced buyer, the terms of the transaction were carefully documented in a letter of intent, to be followed by the actual Asset Purchase Agreement and a multitude of various other closing documents.  As transaction attorney for the seller in the deal, I was asked to review most of the forms of closing documents presented by the buyer, several of which arrived in initial draft form within the last week or two prior to closing.  The buyer presented several employment agreements to be signed at or before closing, including two agreements requested of non-owner employees who were involved in sales and marketing.  These employees were considered key employees by the buyer, given their key relationships with customers, and were asked to agree to typical non-compete agreements in connection with their proposed new employment with the buyer.  Nothing extraordinary to that point.

                  A day or two after the form of employment agreement was presented to the non-shareholder employees, and now just a day or two prior to the scheduled closing date, a serious problem surfaced.  The two employees were refusing to sign the employment agreement with the buyer, mostly because of the non-competition provisions.  As we later learned, these two employees were actively contemplating to leave the company to start their own business, or possibly to work for another company.  They were not restricted by an existing employment agreement or non-competition covenants in favor of the seller, and as a result the employees were in position to hold the entire transaction hostage.  The employees were critical to the business to an extent not anticipated, or appreciated, by the seller.  The situation was eventually resolved by the buyer, no doubt on terms highly favorable to the non-shareholder key employees.  (Deal momentum and the amount of money typically spent on due diligence to that point are strong incentives to work things out.)  Nevertheless, a little advance planning by the seller would have gone a long way toward keeping that transaction on track.

                  In preparing to sell a business, the owner should always consider and address the impact of key employees, or in some cases the lack thereof.  Often the required planning will be to train and develop key personnel, so that the business will be able to survive the departure of its owner.  All too often in smaller businesses, the owner serves in several critical roles, including financial, management, operations and sales.  The business will suffer should its owner become ill or unable to work for any reason.  When the owner is ready to sell the business or no longer able to work, it may be impossible to find a buyer with the proper skill set to replace the departing owner.  A qualified buyer can be expected to have some transferrable skills, including the experience and/or capability to manage the organization.  However, the buyer will not often have detailed knowledge about the business operations, and will almost certainly not have pre-existing relationships with key suppliers and customers.  A period of training and consulting with the departing owner will be useful to bridge some of the knowledge gap, but for many buyers the prospect of taking over a business too dependent upon its departing owner for too many functions will be overly intimidating.  Further, financial buyers such as private equity firms may have no interest in actively managing the business, requiring a strong management team in place.    Knowing that one or more key operations, sales or other personnel will remain post-closing may be critical to buyer confidence.

                  The challenge for some business owners will be to let go of the reins enough to allow key people to develop into managerial roles.  Depending upon the type of business, these key personnel may be a CFO, COO, shop foreman, sales representative, accounts manager, crew leader, shift manager, or head chef.  Key personnel are readily identifiable in most organizations by reference to the key functions necessary to generate revenues.  The more key roles the departing owner is fulfilling in an organization, the more difficult it will be to find a buyer who will feel confident in replacing the owner.  Frequently, knowledgeable and skilled employees already exist, they just need to be mentored and given enough authority to raise their profile within the organization, so that they can be justifiably referred to a buyer as a key manager who will remain with the business.  Redundancy of critical skills is also valuable, for those situations in which one or more key employees may decide to leave.  Generally, the more key employees who will remain, the more valuable the business will be to a larger pool of prospective buyers.

                  It is important that key employees have employment agreements with appropriate non-competition and non-solicitation covenants in place to protect the business, particularly if they have contact with customers.  While courts across the United States have shown reluctance to enforce broad covenants, and in some states they are either altogether illegal or severely limited, non-competition covenants continue to serve a vital function for most companies.  Business owners are justifiably reluctant to develop key employees and to allow them access to trade secrets and key supplier or customer contacts, unless they know that the employee cannot take the information or relationships to a competitor.  This is particularly important at the time of sale.  If a key employee can easily leave and work for a competitor, or go into business on their own, they may be more inclined to do so when the business is being sold – especially if the employee had any misplaced expectation of succeeding to ownership.  While it may be detrimental to find out that the employee is not willing to remain with the business after the sale, it could be devastating to consider that they might actively compete against the business.  Accordingly, it is well worth the expense to engage an experienced employment law attorney to provide counsel on implementing employment and non-competition agreements with key personnel.

                  As a final point, the question often arises as to when employees should be informed about the sale or planned sale of the business.   This is an area where every business is somewhat different, and the particular circumstances should be considered, preferably with an advisor.  However, a few general guidelines may be helpful.  In a typical engagement when we are marketing a business confidentially, only the owner and perhaps one or two key employees will know that the business is for sale.  It seems that there is usually at least one trusted, key employee who is necessary to provide information required for the marketing engagement, or in response to buyer due diligence requests.  Most other employees would only become nervous, and often unnecessarily so, if they knew the business were for sale.  Generally, the buyer will want to keep all or most of the employees, and especially those who are good at their jobs.  Informing employees of the potential sale in advance can result in unnecessary angst, and possibly the loss of good employees.  On the other hand, we have encountered situations in which the owner’s lack of a transition plan has had a negative impact on employee morale, and the employees are inclined to leave due to perceived instability and lack of job security.  In those instances, it may be beneficial to bring employees into the conversation sooner, with an open discussion of the marketing plans, process and timelines.

                  After a potential buyer has been identified and a letter of intent or agreement has been signed, the related question will generally surface as to when and under what circumstances the buyer should be allowed to talk with employees.  From the buyer’s perspective, it is important to confirm that key employees do intend to remain with the business, and on what terms.  It may also be important to the buyer to assess personalities and skills of these employees during due diligence.  If denied access to employees, the prospective buyer may be reluctant to move forward with the transaction.  On the other hand, the business owner/seller will be justifiably concerned about disruption of the business resulting from these conversations.  First, the employees may not have been informed of the potential business sale, for reasons previously noted, and the owner may not be ready to inform them.  Second, the owner will have to deal with the fallout if the buyer does not complete the acquisition for any reason.  Our advice to business seller clients is that a sale transaction is not completed until it is closed and funds are disbursed.  This is especially true if the buyer’s financing has not yet been approved or if the buyer is still undergoing inspections.  Accordingly, it is a delicate balancing act to weigh seller and buyer considerations and determine when to allow conversations between a prospective buyer and employees.  The arguments on both sides will be reasonable, and the course will have to be negotiated carefully.