Transitions 2020: Locking Up Key Talent

By Dennis Boone

Business owners looking to sell, often after a lifetime’s work, may think they’ve paved the way for a buyer’s due diligence by tidying up their books, preparing all the regulation compliance and tax documentation, tightening up receivables and getting the payables reduced. 

And yet, if he’s laser-focused on the cell in Excel that suggests a valuation, they are just getting started. Business brokers, bankers and other financial-services professionals say there is another key step that needs to be taken, and perhaps before any of the other work has started: Locking up your most valuable players to ensure prospective buyers that turnover won’t imperil future revenues.

Sounds like a no-brainer, right? Think again.

“Less than 20 percent of smaller businesses have addressed these issues,” says Mike O’Malley, chief executive at one of the region’s most prominent brokerages, O’Keeffe & O’Malley. “They may start to work on these the last year or two prior to a sale, but ideally they should do this when they start the company or hire new people.”

It’s hard to find a company that doesn’t publicly declare its employees to be its most valuable asset. And yet, brokers say, that asset can be difficult to value. But it has to be done for owners to maximize the valuation of their enterprises.

It’s easy to focus on the numbers and pre-sale processes.

Bill Conway, with CC Capital Advisors, says he’s working on a  sale right now where high levels of employee expertise are required, and where replacement talent is hard to come buy. It’s been imperative for that owner to have those employees on board for a buyer, he says.

“The CEO has been proactive in putting in bonuses for all employees, not just key personnel,” but the clerical and hourly employees, so that as we transition this business, they are all motivated and aligned to stay with the organization. There is critical institutional knowledge each possesses in their own right and function, and the business needs to retain that.”

The key for buyers, say brokerage executives, is to preserve the stability of the organization and day-to-day function. Yes, the new owners will eventually put their stamp on the business, but they have to keep it going to reach that point.

“You don’t want to ask them from Day One to replace a bunch of key employees,” Conway says. “Talk about a nightmare scenario for buyers.”

It’s vital, experts say, for owners to understand  the timeliness involved in the process, both well before a sale and what retention will mean well after it. 

“It’s important for business owners to prepare several years ahead of a sale and consult with advisors to develop a retention plan,” says Doug Hubler of Apex Business Advisers. And on the back end, after a sale, says Conway, “you need  them to agree to stay beyond closing, not just 30 or 60 days, but 6, 12 or 18 months, even  two  years.”

If you do the math on that process, you could be talking about a four- or five-year block of a key employee’s career. It’s not wonder, then, that so many owners haven’t addressed the issue; many smaller companies don’t operate with those kinds of time frame in mind.

The Cost of Inaction

Clearly, brokers say, failure to address the retention factor can carry significant financial consequences.

“What will really affect a valuation is if you sell the business and all the people are leaving,” Conway says. “A few buyers might say they don’t want those employees, but at some point you have to run it either as a stand-alone or a branch of the mother ship, so you’re going to have to have key people who can run the thing.”

 Hubler says that employees who are viewed as “key” to the operation “are an important asset of the business and should be viewed that way when preparing for sale. If there is a risk of these employees leaving after a sale, the value of the business could take a significant hit.” Even worse,
he says, “it could derail a closing entirely.”

The risk to valuations, says O’Malley, “could be in the terms of the transaction, where the seller has to finance more of the business in the form of an earn-out.  Ideally, the seller doesn’t want the buyer to talk with any employee prior to the sale. Usually they do visit with a few personnel, but it’s near closing date.”

“Potential risks and costs can be significant,” says Intrust Bank’s regional president, Kurt Fischer, “For example, a key salesperson or sales director, who has developed loyal client relationships over time and if he/she were to move, that book of business is at risk, thereby creating uncertainty.”

Or, just as potentially damaging, Fischer says, “a key operations manager who has established processes and protocols that could be largely reliant on their knowledge. If that person were to leave, would those processes be negatively impacted?”

And that, say the experts, is where traditional understanding of key personnel start to blur. These are often not the types of executives one might expect to be insured with “key man” policies that mitigate the risk of losing senior executives.

“If you have folks employed by the same organization for decades who  have institutional knowledge—that may be somebody out in a superintendent’s role or a general-manager role—you can’t necessarily replace that experience; they know how to get things done,” Conway says. ‘The key from a buyer’s perspective is to look at census of employees, who has been in what chairs, and for how long, how close are they to retirement, how soon do I need a decision to replace a particular employee or am I better off to hire right out of the chute today, someone who can be mentored to learn the trade or the craft?”

Hubler says his experience is that “the key person is usually a different individual than those identified for insurance purposes. They probably don’t have any ownership in the business and don’t have an agreement to acquire the business if the current owner becomes incapacitated. These are operations managers, sales managers, lead foreman or similar positions of leadership.”

Locking these people up is of particular importance, says O’Malley, because this is a class of employee who has “enough knowledge to go and compete with the company after the sale. Or hold them hostage later on. Salespeople are very important as they know the customers and know the ins and outs of the business to sell the products or services.”

Every industry, though, is different as to the role, he says. “It might be a COO that knows of all of the operations of the business. It could be a highly skilled employee in a manufacturing facility that is the only person in the business to run and operate a very expensive piece of equipment. How much does the company/owner have invested in the person? How many years of knowledge do they have? The longer they’ve been there, the more important they are to the successor once the seller is gone. They can become the brain trust of the organization.”

When defining those who will be of greatest value to a seller, says Kerth, there are two kinds of employee roles: relationship-based, and knowledge-based. “Systems, controls and procedures established in the business can help reduce risk with key staff,” he says, while “cross-training and having multiple employees able to perform can reduce risk.”

The Retirement Wave

Millions of small and mid-size-businesses are going up for sale as Baby Boomer owners retire over the next decade. But retirement isn’t calling them alone. Those same skill sets owners want to lock up for buyers often belong to retirement-aged managers who aren’t looking to extend their careers or reset tenure with a new employer.

While Millennials now account for half the work force and Generation X has firmly rooted itself in leadership roles, “we have seen situations and do see them where the owner, CFO and COO are all within three to five years of each other and close to retirement,” Conway says. That has implications for  sale.

In those cases, “you have to look for a different type of buyer,” he says. “From the financial-buyer perspective, it narrows the field of buyers when they have management that wants to walk away. More uncertainty enhances the financial risk, which can be reflected in the valuation.”

This is why it’s so critical for owners, said Hubler, to start preparing the next level of leadership today, the ones who will transition with the business to the new owner. “When there are multiple key employees nearing retirement age, the buyer has to be able to determine how those positions could be filled in what could be the near term,” he said. “The advantage of long-term employees can quickly turn into a disadvantage if a number of employees are going to
retire and leave the business with a void in talent, knowledge, and customer relationships.”

It’s something that Intrust sees more of, in all areas of companies, Fischer said. “One of the primary items of consideration here is that other personnel are properly trained as the retiree prepares to leave the company,” he said. “Ideally, there would be a runway of transition
where the person assuming the retiree’s role would have time to observe not only the duties of the job, but the relationships (internally and externally) that person manages.”

Under the right conditions, tho-ugh, “as business owners age, responsibilities of the operation are shifted to key employees,” Kerth said, “These employees can be logical owners of the business and there are several transaction vehicles established to facilitate this type of transaction.”

Loose Lips

Compounding the challenge of identifying key people and starting the conversations with them about retention is the real-world issue of how word of a prospective sale can leak out before an owner is ready to have that conversation with the entire staff. Not only can it cause issues of morale and unexpected departures from other vital roles, it can create a dynamic where a vital skill set creates leverage in the minds of people looking to stay on board after a sale.

“Maintaining confidentiality is probably the biggest challenge an owner faces when preparing to disclose an upcoming transaction and yes, employees may feel that they have leverage,” Hubler says. 

However, there are strategies to communicate with key employees and to prepare the business well in advance to mitigate the risk of disclosure and preparing your staff.”

O’Malley believes that “if an owner prepares for the sale and has the employees sign a non-compete, non-solicitation and a non-disclosure agreement while making sure the document is transferable to the owners successors, it’s not much of an issue. The ideal time to do this is when the employee is hired. Then they can decide to give them a raise or participate in a bonus program.”

Some common things that key personnel will want to understand, said Fischer, “include job security (i.e. what changes will be made), will opportunities of advancement be limited; and how will culture be impacted, among others. The owners really have to lean into these areas to understand the depth and breadth of the key employees’ concerns.” Effective tools for securing post-sale commitments, he said, include “retention bonuses, employment contracts, potential for limited ownership down the road, and providing additional management responsibilities or oversight.“

In any case, said Conway, “it’s a sticky conversation,” and one not always easily settled with money—“it’s not a guarantee that an employee is going to stay. It’s certainly an incentive, but there has to be real alignment. If you’re not philosophically, operationally and culturally aligned, money is irrelevant.”