You’re Not the Boss Anymore

July 5, 2024

Adam Adkin and Josie Jeremiah - Tonkon Torp LLP

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It’s nice to get paid. Giving up control of your business? Well… that’s a different story.

On closing the sale of a business, owners realize a dramatic financial return on their investment. However, few buyers are willing to close a transaction and allow the former owners to ride off into the sunset. At a minimum, a buyer needs the former owners to transition knowledge and help establish the buyer as the new owner. In some cases, former owners are expected to contribute indefinitely to the buyer’s growth strategy for the businesses.

Understanding a buyer’s expectations for a post-closing engagement is critical for moving a transaction to closing. Selling owners should therefore be prepared to negotiate the mechanisms that a buyer may use to incentivize their continued engagement.

Are You Ready for This?

More than anything, owners need to come to terms with remaining engaged with their business, but in a different capacity. At the moment of closing, owners transform from the masters of their universe and the final decision makers to employees who answer to the buyer and its management team. The difficulty of living with this shift cannot be overstated and frequently contributes to post-closing disputes. Owners should prepare themselves well in advance of closing the sale of their business.

Strategies for Incentivizing Post-Closing Engagement

Buyers use a variety of mechanisms to keep former owners engaged, including the following:

• Post-Closing Compensation: Selling owners often believe that they would be happy to stick around if they are paid enough money. However, most buyers anticipate that the former owners will become frustrated and recognize that market compensation is likely inadequate to incentivize continued engagement. Accordingly, buyers are more likely to employ mechanisms that delay payment of a portion of the purchase price rather than commit additional resources to post-closing compensation of the former owners.
• Earn-Outs and Rollovers of Equity: To encourage former owners to continue growing the business after closing, buyers may require that a portion of the purchase price be paid as an earn-out (a payment conditioned on the business achieving post-closing milestones) or by issuing rollover equity to the selling owners. Although buyers realize other benefits from each of these mechanisms, buyers often highlight that these mechanisms are necessary in order to align the interests of the selling owners with those of the buyer. See our other articles for more information on earn-outs and the roll-over of equity.
• Retention Payments: More and more frequently, buyers are conditioning payment of some portion of the purchase price on the former owners remaining engaged with the business for a minimum amount of time after closing. This approach makes sense if a buyer cannot justify paying the agreed purchase price if the selling owners were to leave the business immediately after closing. However, the parties should carefully analyze the reasoning for deferring payment of some of the purchase price in this manner, as it easily becomes complicated to negotiate and may have unintended tax consequences.

Avoiding Post-Closing Obligations

For owners who find the prospect of a post-closing engagement unappetizing, there are strategies that can minimize its necessity. The less engaged in operations an owner is, the less value a buyer will see in the owner’s post-closing engagement. Business owners anticipating a sale should therefore establish a qualified and professional management team that is (a) capable of keeping the wheels turning without the owners’ involvement, (b) actively identifying and addressing new opportunities and risks, and (c) dedicated to the business’s growth.

Even if highly profitable, a venture that is heavily reliant on the owner is difficult to sell. If a business depends on the labor of an owner to generate revenue, then a buyer will either need the owner to remain engaged to maintain the revenue stream or replace the owner with an equivalent laborer.

This update is prepared for the general information of our clients and friends. It should not be regarded as legal advice. If you have questions about the issues raised here, please contact any of the attorneys in our Mergers & Acquisitions Practice Group, or the attorney with whom you normally consult.

About Tonkon Torp
Tonkon Torp LLP is a leading business and litigation law firm serving public companies, substantial private enterprises, entrepreneurial businesses, and individuals throughout the Northwest. Tonkon Torp is celebrating its 50th year in business! See our History Timeline for more information, or visit tonkon.com.