For any business considering a sale or acquisition, the importance of management cannot be overstated. In particular, sellers of middle market businesses should take a hard look at their management depth to assess gaps and evaluate the strength of the team. The perspective of management can make or break a deal or, at minimum, influence the ideal acquirer, terms and overall succession planning for a business. In this article, we will explore some of the reasons management is so critical and the steps owners and acquirers can take to provide strong incentives to ensure that key talent remains after the deal.
Putting aside potential M&A transactions, it is not surprising that management talent is the most valuable asset for any business. Even companies with great business models can fail dramatically with poor execution, and management is the core group responsible for execution of a plan. There are a host of ways businesses can provide managers incentives to align their interests in growing the business, including phantom stock, stock options, and sweat equity to name the most common. Each of these has their respective pros and cons, but the important point is that a team who is invested in the future of the business generally feels more ownership of results through a direct benefit.
How is this important for a transaction? Management skill and the ability to execute will have a tremendous impact during a merger or acquisition in areas such as operational performance, buyer interest and exit price. The scale of the impact depends on the type of buyer. “Strategic” buyers are usually in a similar business line or make an acquisition that fits within their organization or growth plan. If a strategic buyer intends to absorb an acquisition into its existing infrastructure, it may consolidate certain functions, such as finance or IT, thereby reducing the reliance on an acquisition’s management team.
On the other hand, “financial” buyers (e.g. private equity groups) will place a greater emphasis on the whole team if acquiring a business as a brand new investment. Most middle market financial buyers are not business operators, and while most have relationships with operating executives who they can use to supplement an acquisition’s senior team, they will spend a great deal of time assessing the team’s capabilities to grow the business.
Companies that lack management depth will find it difficult to attract a premium price at the cost of losing the interest of a large portion of the financial buyer market that seeks to invest in strong teams. Key managers may control client relationships, industry expertise, technical skill, etc., which if lost from the business would substantially diminish the value of the company.
This dynamic makes it incredibly important for sellers (and acquirers) to assess the management team objectively. Some useful questions to ask are:
- Who is running the business day-to-day?
- What are each manager’s key responsibilities and how are they performing relative to expectations?
- Who controls key relationships internal and external to the organization?
- If the current leadership stepped down, who would replace them?
- What are each manager’s short and long-term goals?
- Where does each manager believe the business should go in the future?
- What are each manager’s strengths and weaknesses?
- How dependent is the organization on any one or set of individuals?
Given the value of management to a business, retaining key individuals is standard practice during a transaction. There are many ways to do this from both the seller and buyer perspectives. Sometimes sellers will provide managers they deem critical with a retention bonus at the closing of the transaction for remaining with the business and helping complete the deal. These payments are also partially intended to help protect managers who may not be retained by buyers post-closing.
For those managers who are necessary for the business post-transaction, many buyers typically make deals contingent upon entering into employment agreements with these individuals. Financial buyers also commonly create equity incentive pools for key managers to provide a share of the equity when they eventually exit the business, thereby building a direct link to a manager’s performance growing the business to a long-term, potentially lucrative incentive. On the flip side, this also provides an opportunity for managers to learn more about financial partners to provide input on who they think the right partner would be to grow the company, since managers have a very tangible stake in the outcome.
Stock options are a common form of incentive. While the devil is in the details, the crucial point is structuring options to drive the desired behavior. Setting thresholds for performance are good in theory, but one should be careful about incentives that drive short-term decision making, such as revenue growth targets, which can backfire by focusing on the top line instead of overall profit.
For middle market businesses, the discussion around management also includes a very important consideration: how important are the shareholders to the company’s operations? Shareholder-managers are the norm for many middle market businesses, and such individuals face a succession planning challenge. Exiting the business is very difficult if you control day-to-day operations, key relationships, or long-term growth. Thus, if you are an active part of management as a shareholder, it is even more important to develop a layer of management depth to allow you to extricate yourself from key roles and responsibilities for an eventual sale.
Overall, management is what many buyers are investing in, and a strong team can mean the difference between a successful transaction and stalled succession planning. Furthermore, aligning the incentives of management with shareholders through a variety of forms can create a formula for success by providing a sense of ownership and tangible results by creating shareholder value.
Karl Stark and Bill Stewart are Managing Directors and co-founders of Avondale, a strategic advisory and principal investing firm focused on growing companies. Karl, based in Chicago, and Bill, based in San Diego, have a combined 30 years of experience helping businesses achieve and sustain profitable growth. Their strategic and financial advice helps companies unlock the value drivers in their business and focus investment around the most profitable growth opportunities. Avondale, based in Chicago, is a high growth company itself, and is a two-time Inc. 500 award recipient. The authors thank Avondale’s Sameer Pal for his contributions to this article.
Twitter: @AvondaleSP @KarlStark @BillStewartASP