Rarely do private company owners sell their companies, pocket all the cash at closing, and ride off into the sunset to never worry about their business again. Selling owners and key employees of acquired private companies almost always both play a crucial post-closing role in the 2-to-5-year period after the initial sale. The buyer (particularly any private equity buyer) will lean heavily on selling owners and existing management to continue operating the business day-to-day post-closing. This helps the buyer to learn and acclimate to the purchased business. The continued involvement of the selling owners and key management after the closing is usually a condition imposed by buyers to proceed with the transaction. Given this reality, there are some fundamental post-closing management considerations that are pivotal for selling owners to prepare for before the transaction closes.
Second Bite at the Apple for Sellers
Many buyers require sellers to “rollover” a percentage of their equity into the buyer’s post-closing entity to incentivize the selling owners to have a “stake in the game” going forward to align their interests toward a lucrative second sale of the business down the road. In private equity, for example, the typical “second bite at the apple” horizon is between 3-5 years. (For more on private company rollover considerations, see our previous article here). If structured correctly, the rollover equity can provide sellers with additional and potentially significant financial upside on the buyer’s subsequent sale of the business.
Sellers should carefully vet and validate the buyer’s valuation model to ensure the value of their rollover equity is what the buyer says it is as part of negotiating the overall transaction purchase price. Caution should also be taken to ensure the valuation cannot be manipulated after closing or determined based on subjective factors solely in the discretion of the buyer. In addition, because sellers will only hold a minority stake after the sale and will lack overall control of the business, it is critical to feel comfortable around key provisions in the post-closing governing agreements (like an operating agreement or shareholders’ agreement) that will impact the sellers’ retained equity. Such items include ensuring the adequacy of anti-dilution rights, equal participation rights on sales or subsequent financings, and other rights that prevent the buyer from taking actions that disproportionately impact the rollover equity of the sellers relative to the buyer’s equity.
Employment Agreements for Sellers
It is common for selling owners to continue in management employee capacities post-closing, which means that employment terms (and often detailed employment agreements) will be expected and important for the buyer and sellers. The stakes in employment agreements can become particularly high if a separation from employment can impact the rollover equity of the seller (or if an employment separation can impact the obligations of the parties related to earnout payments if they are part of the deal). (For more on earnouts, see our article here). Well-advised selling owners will negotiate for severance on terminations “without cause” or for “good reason” (terms which themselves can mean very different things depending on how negotiated) and look to avoid the ability for the buyer to repurchase their rollover equity. Buyers, and particularly private equity buyers, will routinely endeavor to negotiate equity repurchase rights based on prices “determined in their subjective discretion” often payable over years with little or no collateral.
Sellers should and will normally push back on these positions to ensure they will get the full benefit of the value of their rollover equity, whether or not they are employed at the time of the second bite at the apple sale. Because the equity rights of sellers will be memorialized in an operating or shareholders agreement, there is a substantial interrelationship with the employment agreement that should be identified and properly drafted. Sellers would be naïve to think buyers will automatically offer up favorable terms to sellers on these aspects of the deal. That is rarely the case and savvy sellers and their advisors should plan to negotiate these terms to obtain mutually fair and sensible outcomes.
Equity Incentives for Key People
In addition to incentivizing sellers after the sale, most buyers and sellers collaborate on and implement a post-closing equity incentive plan for key employees (which can also include participation by selling owners) to help keep those key employees working for the acquired business. These financial incentives most typically take the form of stock options, LLC profits interests, or restricted stock grants. Sometimes key employees who are optimistic about the prospects of the business and the opportunity to participate in the second bite sale will inquire about opportunities to invest some of their own cash in the post-closing entity for a class of ownership on par with that of the buyer and the sellers. Buyers and sellers alike often wait too long in the process to begin to formalize and fully negotiate the post-closing equity incentive plan for key employees (as talented employees will pay attention to these items and will frequently negotiate on them).
Selling owners have a lot more to think about than just the price at closing as the general expectation is that they remain with the acquired business after the initial sale, usually with continued skin in the game via rollover equity. The strength and viability of that equity position are often highly dependent on a post-closing employment relationship. Equity incentive arrangements for key employees will also affect the landscape for both buyers and sellers beyond the initial sale. Linden Law Partners has guided many sellers through these obstacles and opportunities as part of the M&A deal process, always looking for ways to maximize the post-closing success and financial outcomes for sellers. Contact us today to discuss your options if you are evaluating the sale of your business.
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