Retaining the Team: How to Mitigate Your Number One Risk in a Tech M&A Deal

After M&A dealmaking cranked at an all-time high in 2021 with a record breaking 60,000 publicly disclosed deals aggregating over $5 trillion (see our recent article), the waters of M&A cooled considerably in 2022, with only 22,000 deals with a total value of $1.7 trillion year-to-date.

What’s the risk?

On the heels of the “great resignation,” a historically low unemployment rate of 3.7% (October 2022, US Bureau of Labor Statistics), and so much change in how we work, attracting and retaining top talent is more challenging today than ever. This situation continues despite the recession.

Indeed, in an M&A transaction, losing the team required to operate the business, maintain and develop technology and serve customers is considered by many to be the number one risk for successfully executed deals.

Retaining top talent is essential to both buyers and sellers:

• Financial buyers and private equity sponsor rely on the target’s management team to carry on the daily business of the target.
• Strategic buyers rely on the team to integrate the target’s business into the broader platform and create revenue synergies.
• To founders of and investors in the target company, the continuation of the team is important in maximizing the value of deferred and earnout consideration and mitigating any potential indemnification claims.

In the recent few years, companies are (or, at least, have been) offering very attractive incentives to lure employees and fill critical vacancies, making keeping employees even in stable conditions challenging.

Difficulty retaining employees is only compounded when a company enters an M&A transaction. When employees sense uncertainty, they are more likely to look for what they consider to be a more stable and secure workplace.

So what works?

Here are the critical components of any retention strategy:

Compensation

Adequate cash compensation and bonus: Outline a clear compensation philosophy that ensures a minimum base salary range for their position (with upward trajectory) and a variable bonus (with or without a retention component). When structuring a retention and/or ongoing annual bonus program, consider including a purely time-based component and a component that is performance-based. A time-based retention bonus is a targeted one-time payment offered as an incentive to keep a key employee through a certain date. A performance-based bonus should be contingent upon the company and the individual satisfying performance targets by a certain date. Frequently, this is designed to align with the earnout schedule (see the recent article written by our colleagues Emma Blumer and Ashley Lee, we discuss the trending use of earnouts in recent M&A transactions to bridge valuation gaps (Earnout Article). These factors can motivate employees to stay, drive value, and be replicated in an annual bonus program.

Stock equity plans for both management and employees. Adopting and implementing an equity compensation program is an easy way to align management and investor/shareholder interests. Equity incentive plans may include profits interests (if the issuer is an LLC), stock options, stock appreciation rights, restricted stock, and/or restricted stock units. Many companies like to include equity in their compensation program to encourage employee retention and promote employees’ feeling of ownership in the newly combined company. As with cash compensation, an equity program can include time- and performance-based vesting components.

Tip for international employees:  while equity is well-understood (and generally desired) in the United States, be sure it makes sense from a cultural, tax, and securities law perspective before implementing a program for a broader population.

Rollover Equity. Financial sponsors and private equity firms will often require founders to “rollover” a portion of their equity in the seller entity into the combined entity. Historically, the “rollover” equity range can be between 10% and 49% of total seller equity. This means agreeing to accept buyer’s equity in exchange for founder stock instead of cash. In 2021, we saw financial sponsors attempt to require sellers to roll over a higher percentage of their stock as a risk mitigation strategy and a way to bridge the valuation gap. Then in 2022, in a financing environment that saw interest rate hikes and depressed equity prices, we saw some strategic buyers use their stock as a currency for acquisitions. Rollover equity can be subject to re-vesting (based on performance and/or time) and, like equity compensation grants, can motivate key employees to work hard to increase the enterprise value of the target company post-closing.

Tip for the unwary:  beware of private equity buyers who grant rollover “schmuck” equity that is junior to sponsor equity and which is underneath an accruing dividend as well as senior liquidation preference, and other conditions to transfer (e.g., continuing employment, minimum IRR condition, etc.).

Non-Compensation Related

In looking at the target’s workforce, we see companies adopt strategies focused on Generation Z employees and the intangible considerations they value as much, if not more, than compensation.  Some examples are included below:

Traditional Employee Benefits. Be sure that the company’s benefit programs are market. Health insurance remains an important factor for many employees (even despite the existence of health insurance exchanges). Some 401(k) retirement plans have also “modernized” – building in benefits like student loan “matching” contributions that may catch the attention of employees who may not be particularly interested in traditional retirement planning.

Opportunities for career development: Employees often feel more motivated when ample growth and professional development opportunities exist. If employees feel there is room for professional or personal growth, believe there is a path to increased compensation, and believe leadership cares about them, they will stay. Giving employees opportunities to increase their skills instills a sense of accomplishment, serving as a strong motivator, and providing employees the chance to improve their skills can also impact an organization’s overall success, creating a win-win situation for all involved.

Support their well-being: Workplace flexibility and support for well-being are increasingly important to employees across the board, particularly parents or other caregivers. They want employers willing to work with their schedules, meaning possible four-day workweeks, flexible hours, or expanded benefits packages. Companies offering employees benefits such as on-site childcare and other services also have an advantage when merging companies. More importantly, culture has proven to be critical factor employees consider when deciding on a move. Often, both buyer and the company would have assessed cultural compatibility as part of their evaluations of the deal – and it is important to communicate the positives / similarities in culture to employees.

Communication

In our experience, communication is the most crucial workplace motivator for employees – and a key component of any post-M&A transaction integration process. Increasing communication during the merger process is about opening up lines of dialogue to reduce confusion and instill confidence in your employees that their jobs are secure. Without effective lines of communication, rumors swirl, people become nervous, and they make decisions based on incomplete information. Communicate regularly and effectively, and you can help put your employees’ minds at ease.

To start, focus on developing and implementing a tailored employee retention strategy before the transaction closes, beginning with a clear, consistent, coherent, and compelling mission statement from both the buyer’s and seller’s management team. This will allow both organizations to provide the support employees need to understand their roles in the newly combined organization and demonstrate the value of human capital to achieve success.

Of course, the timing of such communication are sensitive issues and is often dictated by deal circumstances (e.g. the number of employees who are already aware of the transaction, whether customer/vendor communications have been made, whether there are any particular sensitivity issues around the deal, etc.).

One of the biggest challenges to employee communications is that sellers want to avoid a breach of confidentiality or moving the flag before the deal is certain. Sellers will typically object to any disclosure to anyone on their team before the definitive agreement is signed. Buyers can attempt to mitigate this concern by making communications with key team members part of the diligence roadmap, allowing them to build relationships. Remember that diligence is always two-way.

Highlight what is NOT changing:  There will be a subset of the employee population who will fear change. When a company is acquired, it will create anxiety. This is particularly true in an asset sale context, where employees will experience a termination of employment at closing. To combat this anxiety, emphasize what is not going to change. When possible, announce that the leadership that is staying in place, processes and procedures that will remain the same, company headquarters, etc. If employees feel secure that they are coming to work at a place the day after closing that resembles work from the day before closing, it can alleviate a great deal of concern.

Deal tip:  many definitive agreements include post-closing employment covenants to give comfort to employees that they will be given offers, that their compensation and benefits will be no less favorable, and address other “social” issues. As a seller, consider including this type of covenant and, as a buyer, monitor post-closing benefits and compensation to ensure compliance.

Highlight what IS changing: What are the new and exciting things that will come from this transaction, and how will the existing employees benefit? Are there new benefits they did not have or opportunities for advancement that did not exist? What does the new employment agreement or handbook (if any) say about PTO, remote work, and travel policies? Showcase the positive aspects that employees can take advantage of so they can start to get excited about some of the changes ahead.

Deal tip:  if the deal is structured as a stock purchase or a merger, the existing employment arrangements will survive the closing if no action is taken. However, buyers will typically review key employees’ employment terms during the diligence process. They may request certain terms that buyers either deem undesirable or inconsistent with their policies to be amended as part of executing new employment agreements in connection with the transaction. Buyers will often undergo “title mapping” to determine the roles and titles of the transferred employees as part of the deal make sense. These great tools make people feel motivated, incented, valued, and retained. Buyer should also review any existing benefit plans and confirm they are amended, to the extent necessary, to include the target company.

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Retention failure is one of the leading causes of failed post-closing integration and success, but retaining employees is within the control of buyers and sellers in M&A transactions. Whatever happens in 2023, positive or negative, employee retention will be a key driver.