Once we get past the exhaustive work of finalizing an LOI (yes, it is exhausting and thrilling at the same time), my clients immediately start asking me how much they should compensate the non-shareholder management team or key employees.
I think this falls into two categories: a sale bonus and a retention bonus. They both serve different needs, so let’s look at each one.
Sale Bonus
A “sale” bonus is the bonus you give your people for staying with you all the years it took you to grow and make the company prosper; after all, you could not do this yourself. If a team member (I prefer this terminology over “employee”) has been with you for 5 years or more, they should be considered in the pool of dollars allocated toward a “sale” bonus. Of course, not every team member needs to be rewarded equally, nor do you need to establish a set amount based upon years. Instead, it should be determined by who has made the most significant impact on the growth of the company and how long they have been with you.
Here is an example: I knew a few years in advance that I really needed a COO to complement my CIO, CMO, CCO (Chief Compliance Officer), and CFO. I know that’s a lot of “O’s”, but since the rest of the team was already burdened with plenty of other tasks, that operations person would bring an opportunity to move forward key initiatives that the others didn’t have the capacity for. That person was also needed to run the company should I step out of my role as CEO; the other “O’s” really weren’t’ up to the task. Therefore, I hired our COO 24 months before we sold. While this person had not been with me as long as the rest of the management team, they were critical to the sale, so I compensated them as well at close.
It was basically this team, along with my controller, who got a letter from me one month prior to our close that indicated the amount they would receive if we closed the transaction. I had NOT told any of them about the pending sale until one month before the close. I felt this would be the best way to handle it, because I wanted to be absolutely sure the deal would happen, and I didn’t want to create any FUD (fear, uncertainty, doubt) by telling them sooner. That was my situation; yours may be different. Your management team may be critical to involve well in advance of one month to help with due diligence and other items that come up as part of a sale, so you may not be able to wait that long. The buyer will also want to speak with management, but if you DON’ T want your team to know in advance, I feel you can also push this off a little until some of the due diligence is done.
Now comes the question of how much of your sales proceeds (i.e., cash at close – not future earnout) you should allocate to these very important team members? My guidance is 10 – 20%, depending on how many team members there are. The more people, the higher the amount you need to allocate. Having said this, I have seen sellers who have sold their company for over $20M (cash at close) and only allocated 5%. I think that may end up biting you in the end, though, especially if one or more teammates find out how much you earned in the process. But again, this is ultimately up to you and how much time you currently spend in the business. The less time you spend, the more reliance on your team, the more you should compensate them (again, if they are not already a shareholder).
But don’t go overboard! Let’s say you want to share a 750K sale bonus with a key employee. Maybe this is enough money for them to fund the remaining of their retirement plan, and after receiving this amount, they no longer need to work and give notice shortly after the sale. This will not help you realized your earnout, so let’s shift our thought to retention bonuses.
Retention Bonus
To me, a retention bonus or stay bonus is equally, if not more, important than a sale bonus. Unless a sale is 100% cash upfront, you will need your team to help you execute on future revenue and operations in order for you to realize your earnout or seller-note. Therefore, a retention bonus is used to incentivize a key employee to stay with your company for a specified period of time after a sale or merger.
Retention bonuses are usually based on the key person’s annual compensation, combined with the effect of losing them. According to Mercer’s Survey of M&A Retention and Transaction Programs, median retention bonuses paid by U.S. companies range from 25 to 95 percent of base salary, depending on the position. Regardless of the retention bonus amount paid, it has to be personally meaningful to the key employee. I would recommend between 50 – 100% of that person’s annual compensation at a minimum, and possibly some long-term equity as well (i.e. a portion of what you are offered as part of your terms).
If you really want your team to stay even longer, and you have been given an equity option, you will want to share that as well, as that may turn out to be larger than the sale bonus and retention bonus. This works well for those team members who would continue working for at least 5 more years. Here, you might want to allocate 5 – 20% of your long-term equity. If, however, that person doesn’t stay the entire time, their allocation of equity will then revert back to you, so there is really no downside of doing this.
There are cases where the employee won’t stay on for longer than three to six months, as their job may be eliminated as part of the merger. In these cases, I would also consider a small retention bonus as they most likely will be needed as part of the post-merger integration. Very often, I see that marketing people are terminated. But before they are, they need to help move over or rebrand assets they originally created, or help transfer other marketing assets to the new owner.
Now that we understand the two types of bonuses and what they might be as a percentage of salary, here are a few other questions that typically come up and how you might address them.
Can the buyer pay for retention bonuses?
I get this question all the time, and my answer is “Yes.” The buyer can, and sometimes does, pay for part or all of the retention bonus, as they want to make sure that the management team stays. I recently closed a transaction where the buyer not only allocated dollars toward a retention bonus, but also allocated part of the equity payout to the management team. That is rare, however, so you should assume that YOU will be one who pays a retention bonus or offers up some of your share of the equity if they stay for a certain period of time. I personally was not able to get my buyer to pay for a retention bonus. In the long run, though, once they truly understood my team member’s value, they did significantly increase their salary to make sure they stayed with the company.
When to pay a retention bonus?
Retention bonuses should be paid out a specified number of months AFTER your deal has closed: not before and not at closing. Remember, you need them to stay on with the new owner. Most retention incentive bonuses are payable within 3 to 12 months after a deal closes. For key employees who are critical to long-term success, it may be 24 to 36 months. Stay bonus agreements can also have an acceleration provision where they become payable if employment is terminated by the buyer. The key here is to keep the team member incentivized long enough to ensure you can achieve your earnout. After that, it is really up to the buyer to incentivize your team, and they often do through salary, bonus structures, and other forms. For example: I sold my second company to a large CPA firm. Their incentive took other forms, such as a much richer benefit plan (from health insurance to PTO days to health incentives).
If you are paying the retention bonus, you will possibly want to escrow that amount in a stock transaction, since you will no longer have a company to pay those proceeds from. If you have an asset transaction, then the corporate shell may remain intact, and you can leave the money in the corporation, pay it out of there in the form of a 1099, and still be able to take the deduction. You should speak to your tax advisor to understand the advantages and disadvantages of each option.
Finally, this is not the time to penny pinch, nor is it the time to bonus everyone in the organization. Also, make sure you take into account the tax considerations of the bonus; consider grossing up the amount so they actually receive the true amount, and not some lesser amount that just had 40% taken out for federal and state taxes.
Conclusion
In conclusion, retaining key staff affects the overall success of most M&A deals. Key employees drive customer retention, product and service quality levels, and even business survival in some cases. Bonusing key employees and management through both a sale bonus and retention bonus rewards them not only for their past performance, but also for their future productivity.
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