The Importance of Independent Sell-Side Management Team Representation in Middle Market M&A Transactions

Jesse S. Angeley
Director, Corporate Department
Published: MassCPAs Sum News (January 2024)
January 3, 2024

One of the more important factors impacting private middle market mergers and acquisitions (M&A)[1] deal success is the role of the target’s senior management team prior to, during, and after the closing of the transaction. Depending on the size of the target the senior management team may consist of a full C-suite (CEO, CFO, COO, CMO, CIO, etc.) or it may be a smaller team with each member responsible for multiple departments or functions. Whether large or small, the management team plays a critically important role for the target in private middle market M&A transactions and buyers (especially financial buyers) often view management team continuity after closing as a must-have component of the deal. Yet unless management team members are also significant equity owners of the target, their interests may not be adequately represented in the transaction without independent counsel. As explored in this article, it is in the management team’s own interests and the collective interests of the target (also referred to as the seller in this article) and the buyer to have independent legal representation for the management team throughout the transaction and why, given the management team’s importance to transaction success, in some cases it should be considered a transaction expense and paid by the seller.

Generally, the management team has the greatest understanding of a target’s business and, given such depth of understanding, often plays an outsized role in the due diligence process, preparation of the disclosure schedules, and ultimately the success of the closing. The target looks to its management team to maximize the transaction value.  Buyers frequently desire to have the management team continue with the business after closing, and in many transactions management team continuity is a critical issue for a buyer, without which the deal may not be as attractive resulting in a lower purchase price or, in a worst case scenario, the buyer abandoning the acquisition entirely.

In a typical middle market M&A transaction the target (and sometimes seller separately) and the buyer will be represented by experienced teams of attorneys. Yet management teams infrequently seek out representation[2] of their own interests in the transaction from the outset despite their own participation in the deal, instead often piggy-backing with target’s counsel for guidance on issues affecting the management team. This is ill-advised because their interests are not always aligned and may be adverse on certain issues.

Some of the most important issues for management teams in an M&A transaction are how transaction bonuses are structured and the terms of the management team equity rollover. Other issues such as post-closing employment terms and the structure of the buyer’s equity incentive plan are also important to management team members but outside of the scope of this article. These are complex issues often involving tax, securities, ERISA, and other subject matters requiring competent and experienced counsel. Failing to involve management team counsel early in the transaction to adequately review and negotiate these issues prior to closing may result in an unhappy management team and that doesn’t bode well for the seller or the buyer.

Transaction Success, Stay, or Completion Bonus.  When considering a potential sale a target wants to ensure its senior management team is committed to maintain employment through the closing (and after if desired by the buyer) and remains motivated to actively assist with the transaction. The management team will likely bear the primary responsibility for responding to the buyer’s due diligence requests and taking the lead in negotiating certain deal terms on behalf of the target. Transaction bonuses are a common device to incentivize management team members heading into an M&A transaction.

There are several common transaction-related bonuses offered to management team members. The structure of transaction bonuses is frequently modified or combined with other bonus conditions.  A “completion bonus” is earned if the employee continues employment with the target through closing. A “stay” or “retention” bonus, similar to a completion bonus, is earned if the employee remains employed through the closing and for an agreed period thereafter with the buyer. A “success bonus” is earned upon closing and the amount of the bonus is variable based on the relative transaction value achieved for the seller compared to a target transaction value. Depending on the nature of the bonus, importance of the employee to the target’s business, and completion of the transaction, these bonuses may range from 50%-200% of the employee’s current compensation.

Each bonus agreement will be memorialized in a written agreement usually prepared by the target’s counsel. The agreement itself will include the eligibility criteria and conditions precedent for the employee to qualify for the bonus and it may include other terms that alter the employee’s employment arrangement, provide severance rights, or contain a release of claims – provisions that should be reviewed and negotiated by experienced counsel representing the employee’s interests.

Certain complex tax issues may be implicated by a transaction bonus, such as Section 409A of the Internal Revenue Code (the “Code”) that addresses non-qualified deferred compensation and, depending on certain factors, Section 280G of the Code that governs so-called “golden parachute” payments to senior executives. Non-compliance may result in fines and penalties for the employee. These complex tax issues require review and analysis from advisors representing the interests of the management team member receiving the bonus payment.

Management Team Rollover.  A common tool used by many financial buyers to ensure management teams “have skin in the game” after closing is the equity rollover  in which, assuming the management team holds equity in the target, the management team members exchange some of their target equity for buyer equity at closing. A rollover typically is used to make sure the interests of the management team and the buyer are aligned on increasing the value of the target after the closing. There are various rollover structures that may be utilized and it is important for management team members to fully understand the terms of the buyer equity being offered, including the rights and obligations of the equity and the financial and tax effects to the management team members participating in the rollover. While not always negotiable it is important for management team members to have a clear understanding of these terms.

Buyer rollover equity usually is subject to a call or buy-back right of the buyer upon the occurrence of certain events, such as employment termination, disability, and death. The purchase price for equity when the call option is exercised by the buyer will vary depending on the circumstances triggering the call and may be negotiable with the buyer. Depending on the management team’s leverage in the transaction, a “put” right for the employee as well as other terms of the buyer equity may also be negotiable.

Lastly, but importantly, any rollover requires careful consideration of, and planning for, the tax treatment and potential tax consequences to the management team members. Tax treatment of a rollover depends on many factors, such as the tax identities of the parties involved (partnership, C corporation, S corporation, pass-through LLC, etc.), nature of the equity to be exchanged, and the buyer equity to be issued, to name a few. Most rollovers are structured to allow participants to defer taxes on the rollover equity (but not the cash proceeds from the transaction). This allows rollover participants to delay taxes on the exchange of equity in the rollover until the next exit. There are other ways to structure a transaction that includes a rollover component and each may (and likely will) effect the tax treatment of the management rollover participants. Suffice it to say, the analysis can be complex but necessary to ensure the rollover is structured as tax efficiently as possible and the management team members participating in the rollover understand the tax treatment of the exchange. Depending on the management team’s leverage in the transaction, the management team may be able to negotiate with the buyer for a more tax-favorable rollover structure.

There are other transaction issues that will have a direct impact on the management team and that also require independent representation, such as post-closing employment terms and the buyer’s equity compensation plans. Some of the issues and negotiations in the transaction process put the management team in an adverse position to the seller or target (transaction bonuses) while other issues may not directly affect the seller (post-closing employment terms and equity compensation for management team members).  These issues are not only important enough to the management team to necessitate independent representation in the transaction, but considering the crucial role the management team plays in the transaction for the seller, the seller should consider reimbursing the management team for its legal expenses throughout the transaction process.  Doing so will reflect not only the value of the management team to the target and recognition of its contributions to the transaction, but also signal to the management team that, in some respects, the seller views the management team’s interests as important as its own.

[1] This article focuses on the role and interests of the management team in private middle market M&A transactions. Certainly some of these same issues and considerations may arise in public company M&A transactions but less frequently so than in private M&A deals.

[2] Common or collective representation of multiple management team members is not always feasible and in some cases may be prohibited by attorney ethical standards and rules.