Valuation & Litigation Services Blog

Compensation Considerations

Compensation Considerations for the Buyer in an Acquisition of an Operating Entity

For many companies, compensation and benefits are one of the largest recurring expenditures. If you are looking at buying a privately held operating business or a division of a publicly traded company, here is a brief discussion of issues to consider during your due diligence and offer determination processes.

Do I need the executives to stay on?

If you aren’t an operator in the target’s industry, chances are you will want some or all of the target’s current executive group to join your operation. Examine the employment contracts and compensation (including short- and long-term incentives) programs, if any, that the target has in effect. This will give you some guidance as to the types of programs that the executives will be expecting from you. Review existing programs for legal issues, and to determine if they fit within your corporate culture and your desires to grow the business.

If there are no programs, you would want to set up employment agreements with non-competition clauses (where legal), and consider implementing some long-term incentive programs that will keep the executives motivated and will serve as “golden handcuffs” which impede their ability to leave.

One challenge that you may have is that executives who receive large (compared to their annual compensation) payouts as a result of the acquisition might be hard to retain—they may “retire” or use the payout to start their own business.

Do I need the owner(s) to stay on?

If you need the target’s owner(s) to stay involved after the acquisition, you have decisions to make about how that person is paid for his/her ownership interest.

  • If you structure the transaction with a purchase price and an employment contract, you will generate a federal income tax deduction for reasonable payments under the employment contract.
  • If you structure the transaction with an “earn-out,” so that the seller receives more payments if the target reaches performance goals, you might keep the seller more interested in the target’s success.
  • Consider including a non-competition agreement as part of the acquisition, which would allow you to stop future/claw back already-made payments if the agreement is violated.

What areas should I review as part of my due diligence?

You should look at the following, at a minimum:

  • Employment contracts—are there any provisions that will cause you, as opposed to the seller, to make payments or maintain benefits?
  • Tax qualified retirement programs—are they in compliance with the law and IRS filings? Is there an obligation outstanding for which you will be responsible (such as an underfunded pension plan)?
  • Welfare (health benefit) programs—if the target is ‘self-insured,’ review the operations of the program (e.g., assets, claim history, outstanding and future claims, stop loss provisions). If the target is fully insured, review agreements with the insurers. In either event, make sure that programs are compliant with ERISA and IRS requirements, such as IRS Form 5500s and underlying plan documents.
  • Litigation—is there any current or pending litigation or governmental agency actions/investigations regarding any of the above programs?

How will this acquisition impact (culturally or operationally) my current operations?

Compensation issues are a popular topic around the water cooler. Unless the target’s employees are treated completely separately (both physically and organizationally) from the rest of your businesses, bringing the target into your compensation and benefits mix can cause issues with your current employees. You should be concerned about pay disparity (e.g., are people doing the same job being paid at the same rates) if you are already an operator in the business. If you install a long-term incentive program for the target, and you don’t have one for your other operations, your current executive group may feel slighted.

On the other hand, bringing the target into your operation may give you a reason for evaluation and potentially changing your current programs. Cost efficiencies will occur if tax qualified retirement programs are administered together, rather than separately. The target company may have a better system for administering pay. If your health benefits are fully insured, you may receive a lower rate as you have a larger group.

Do you have questions about developing a winning M+A strategy, or are there other transactional challenges you face? Please contact Ken Haffey, CPA, CVA, CGMA, CFP at 440-449-6800, email Ken or visit http://vlas.skodaminotti.com/valuation/merger-and-acquisition-valuation.

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