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The Dark Side of Transferable Value

Submitted by John Brown on Fri, 06/26/2020 - 8:00am

In last week’s blog post, Owner Dispensability: The Key to Transferable Value, fictional business owners Gary and Ida Nella met with an attorney, Lisa Thomas, to discuss the preparation of employment agreements for the managers that the couple planned to hire. When Lisa told them how much it would cost to do so, Gary and Ida decided to use online software instead. We pick up their story four years later.

Lisa was surprised to see Gary and Ida Nella’s names on her calendar. Four years later, she still remembered the abrupt ending to their meeting about employment agreements and incentive planning for two incoming key employees. She also remembered that the couple mentioned leaving their company in five years, so she wondered if they knew that she did not practice M&A law.

As soon as Lisa closed the door, Gary began with, "We should have listened to you four years ago!”

Lisa asked, “Did things not work out with those two employees?”

“Oh, they did a great job and for a while everything was great,” Ida responded, “But about a year ago, they mentioned that they wanted to buy the company.”

Lisa looked puzzled. “Isn’t that what you wanted? To sell the company?”

“Eventually, yes,” responded Gary, “But we weren’t quite ready, so we put them off and…”

Ida jumped in, “Three days ago they handed in their resignations!”

“And that's not all!” Gary added. “Yesterday we discovered that they've opened their own machinery shop and taken half of our employees with them! Almost every customer we’ve called has either not returned our calls or told us that they’ve found ‘another shop.’ We need you to sue them!"

The Nellas had benefitted from the upside of creating value—transferring the responsibility of running a company and generating cash flow from owner to employees creates value that buyers want —but, they just learned the hard way about the dark side creating business value. As employees assume meaningful responsibility, the owner’s relationships with employees and customers weakens.

Lisa first asked to review the two-page employment agreements that Gary had created to see if they restricted the employees' ability to compete or solicit customers and employees. Sure enough, they did not. Now the timing of their departure suddenly made sense. The Nellas paid the bonuses in cash within 30 days after the end of the fiscal year. The company’s fiscal year had ended 35 days prior to this meeting. That meant that the employees had received their checks and resigned two days later.

“Gary,” Lisa began, “According to these agreements there's nothing you can do.  You may remember that we talked about including non-solicitation provisions in the employment agreements when we met four years ago. Those provisions would have prevented the key employees from taking other employees or customers.”

Gary looked so uncomfortable that Lisa hesitated, but she continued, “Perhaps you remember that I thought we should create an incentive plan to withhold half of each year's bonus and subject it to vesting. In order to receive the entirety of their bonuses, the employees would have had to remain with your company.”

Gary’s face told Lisa that she’d gone far enough. “I would be happy to create these agreements when you hire replacements for your two key employees," she offered.

“I think it's too late for that,” Gary said quietly.

“He’s right,” Ida agreed. “There's really nothing left in the business that’s valuable. I think it’s time to wind up the company and liquidate it."

The Nellas learned that there are two sides to the transferable-value coin. On one side: in order to realize full value for a company, owners must be dispensable. And on the other side: as owners become dispensable, key employees don’t always deepen their relationships with clients and employees. They realize they’ve become indispensable. They also realize they can get rid of with the owners, form a new company, and take whatever employees and customers they choose without a proper employment agreement drawn up.

BEI offers a software system for advisors that efficiently puts together a meeting agenda and generates a discussion draft plus recommendations.  This includes things like NSA agreements or covenants, to not compete when recommending employment agreements for key employees to present at meetings like the one Lisa and the Nellas had four years ago. The Nellas could have completely protected their business if Lisa, as their trusted Exit Planning advisor, could have better highlighted the severity of this step and had a tool like BEI’s to quickly create the documents they needed.  

Takeaways:

  • Without advisor involvement, owners do not typically know how to create transferable value.
  • Left to their own devices, owners do not make provisions for “the dark side” of transferable value. It is essential to design employment and incentive agreements that protect companies and their owners from losing customers and employees.
  • The ideal time to begin discussing employment agreements, incentive arrangements for key employees and non-solicitation agreements is at your next planning meeting with a business owner.


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