M&A Issues: The Stay Package
We continue our discussion of M&A Issues this week on MBA Mondays. Today we are going to talk about the “stay package.”
When a company acquires your business, they are buying the people as much as anything. Experience has shown that the most successful acquisitions require the team to stick around, at least for a while. But if everyone is getting cashed out day one, there is very little incentive to stick around. Therein lies the stay package.
There are a number of different variations on the stay package to deal with different deal scenarios. I will group them into three main categories for the purposes of this blog post but there are many variations around these three main categories. Every deal is different. There is no standard deal in the M&A business.
1) When the employee and founder equity is worth a lot of money and much of it is unvested – In this scenario, the buyer usually assumes the unvested equity, converts it to unvested equity in its cap table, and uses the remaining unvested equity as the bulk of the stay package. The buyer is likely to adjust the stay package by issuing new employee equity or cash bonuses to certain members of the team to further incent them to stay.
2) When the key employees have equity of significant value and most/all of it is vested – In this scenario, the buyer is going to have to come up with a large new employee equity grant or cash bonuses for the key employees and it often comes out of the sale price. Let’s say your company is getting purchased for $300mm and the buyer believes it will take $30mm of cash or equity in the buyer to incent the key team members to stay. It is typical to see the purchase structured as $270mm for the company and $30mm for a stay package for key employees. In this scenario, the rest of the team usually has remaining unvested equity and will typically be treated similarly to scenario 1. It is common practice, but by no means standard practice, for the employee equity and investors equity to be split up and treated differently in this kind of situation. In one situation I was involved in, the founders owned 40% of the company and the investors owned 60%. The company was sold for $100mm and the investors were cashed out for $60mm and the founders got a two year stay package for $40mm plus some additional equity in the buyer’s stock.
3) When the key employees’ equity is worthless – This usually happens when the company is being sold for less than the total invested capital. The deal most investors make is they get their money back before the founder and employee gets paid out. In an investment that doesn’t work out well, this means the founder and employee capital is worthless in a sale. But the buyers know this and won’t allow all of the sale consideration to go to the investors, who don’t matter to them, and none to the employees, who matter a lot to them. So what buyers typically do in this situation is create a carveout for founder and employee equity. The carveout can often be as high as 25% of the total consideration. I have seen buyers propose 50% or more but those deals don’t get done because investors usually control the exits and they need to feel that they are being treated fairly. The founder and key employee carveout is usually paid in cash over a two to three year period.
The typical stay package is for two to three years. The consideration is generally paid ratably over that period. But it can be back end loaded to further incent the team to stay.
Some deals can include an “earn out” which is additional consideration based on the performance of the business. Earn outs can be for the entire shareholder base or can be made available only to the key employees. Earn outs can work well when the business is being left alone and the metrics are easy to establish and the team feels confident they can meet them within the confines of a larger organization. I don’t consider earn outs to be stay packages. They are a different beast for a number of reasons. But they can be very effective at keeping the key employees around.
I’ll end this post by saying that I can’t think of a founder or key early employee of one of our portfolio companies that has stayed at a buyer for more than three years. Most are gone after two years and some leave well before that. There are a host of reasons for this, and most have to do with the psyche of founders. So it is wishful thinking to expect a founder or early key employee to stick around for the long haul, but getting them to stick around for a couple years can be done and should be done. So make sure your deal has a well thought out stay package. It is in everyone’s interest to do so.
From the comments
Fred, What is your response to your alternative 2 above as an investor in the company? You will receive proceeds per the liq pref waterfall, but a healthy percentage of enterprise value is being carved off the top and given to certain employees instead (which means your total proceeds are being reduced)? Do you view this as an acceptable deal term (especially if the buyer is insisting on it), or an end-around on the liq pref waterfall (what the shareholders in the target company agreed to re how proceeds would be paid out in the event of a sale of the company)? What dynamics are you seeing between investors and management when these types of structures are offered up by buyers?
To which fredwilson answered:
if it is not excessive, i am OK with it. as an investor you have to realize that a lot of the value is the team
This article was originally written by Fred Wilson on February 7, 2011 here.