Harnessing Financial Incentives is the Key to a Successful M&A

Mergers & Acquisitions, Financial Incentives, Change in Control, Soft Due Diligence

This blog has been written with our partner Don Hilton at Distinct Capital Partners an independent investment bank that provides value-added mergers and acquisitions and corporate finance advisory services both in Canada and internationally and was Inspired by an article written by Lynne Lacoursière.

Any buyer should ensure as a priority that they have a full understanding of the incentive arrangements for the top team in a company that is being acquired. Human assets are just as important if not more so, than physical ones and with the shrinking labor pool, wasteful not to retain the important team members in the acquired organization.

With the sheer volume of work associated with a transaction, executive compensation plans which will largely remain intact when ownership of the employment entity changes, sometimes tend to get sidelined. That is a mistake and in fact needs to be at the front of the diligence schedule. A purchaser may be forgiven for taking this for granted once agreement has been reached, and the owner and/or their top team has bought into the vision and agreed to come over.

Take a look at how a Private Equity (PE) investor approaches compensation for the seller’s team and this may help demonstrate why this is so critical to a successful transaction and why it is important whoever the buyer happens to be.

First a PE investor will want to know that the executive team, so influential in maintaining workforce engagement during ownership transition, is incentivized to make the deal happen and motivated to stay with the organization beyond the transaction’s completion.

This will involve examining whether incentives put in place by the seller vest or become payable on closing or whether the acceleration of vesting is discretionary. It will be important to make sure these represent an appropriate reward for management’s efforts in completing the transaction and that any uncertainty on how or whether they will be paid is removed.

The buyer will want management to be energized by and focused on completing, the transaction, and not be distracted by worries about losing their job. If there is no incentive already in place to motivate completion of the transaction then one may need to be created in the form of parachute payment or “stay” bonus depending on the anticipated contribution of the recipient. Care should be taken that the payment is not so large (e.g. a “Change-in-Control” payment) that it becomes an incentive leave so that it can be collected and, if made to a US resident whether it will attract excise tax that reduces its impact.

If management holds equity in addition to incentive awards this an indicator of commitment to the company and potential future loyalty. A PE buyer will often award senior managers that they want to transition to the new company, a one-time award to motivate them to remain until the PE’s planned exit date. A PE buyer will usually have a finite ownership period in mind and will tie the vesting of this initial award performance or time restrictions so that payment coincides with that exit strategy. Another type of buyer however, might harness payout to an envisioned strategic milestone of the merged companies.

The PE buyer’s primary goal is to increase value and awards will typically pay for value added over and above the initial grant (e.g. options) rather than in full value stock or units. These will nonetheless provide management with “skin in the game” and motivate the desired behaviors.

The PE buyer will develop an understanding with management ahead of closing and firm that up in a term sheet, executed simultaneously with the purchase agreement. With the seller they will calculate the necessary equity pool, distribution scenarios, and reserves for future hires and promotions as well as rules surrounding an executive’s early departure and whether outstanding awards will need to be repurchased. Broad terms are agreed in advance with transferring managers with the texts of incentive plans, shareholders agreements, and employment contracts finalized in the period before the deal closing.

Whether a PE buyer or another type of purchaser it is imperative to have the sellers team motivated to complete the transaction, remain with the business and to achieve its strategic objectives.

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