Most experienced dealmakers agree that when it comes to making an acquisition pay off, the soft stuff is often the hard stuff -- in other words, human resource issues and the cultural impediments to combining two organizations can either make, or break, a deal. One of the most important of these issues is executive compensation. The good news is, it's an issue you can address.
Clashes in executive compensation systems are most likely to occur when a larger company buys an entrepreneurial one, especially in life sciences or high technology. Smaller, more entrepreneurial firms often weight their comp plans toward equity, since they need to conserve cash. Larger firms tend to focus more on cash and less on equity. Note, though, that this kind of dichotomy can also occur in a merger of equals where the two firms have radically different cultures and approaches to executive comp -- one aggressive, the other more conservative.
To retain executive and key employee talent, you need to determine up front how to bridge any gaps. People want to know early in the game what's in it for them and whether they will they have the potential in the new compensation scheme to make what they think they should.
The time to compare the two compensation systems you mean to combine is during due diligence. The areas that are critical to look at include:
Market positioning: Where does each company try to position its executive pay rates compared with the market rates for such talent? Does one firm have a 50th percentile strategy and the other a 75th percentile strategy? A downward change in the level of targeted pay positioning for the acquired company executives often means reduced bonus targets, flat salaries and lower levels of long-term incentive grants.
Mix of compensation: The components of pay (fixed vs. variable, short-term vs. long-term) matter a lot. If one company has historically been a bigger user of stock and the other has not, and is not likely to be in the future, this may affect the ability to retain the talent needed to make the deal successful.
Approach to severance and change in control. What are the two companies' philosophies with respect to executive severance and change-in-control agreements? Reducing or eliminating such provisions for the newly acquired company executives, when they had them previously, often creates retention risk.
Another major factor affecting your ability to retain critical talent is the payoff that executives at the target are getting as a result of the deal itself. Here, you have two main concerns:
1. If the amounts are potentially life-changing, it's critical to determine what, other than money, will compel these executives to stay. If the answer is that nothing will, you obviously need to think about how you'll replace them.
2. If the amounts are not life-changing, is the value proposition for the executive, both at the onset and over the next two to three years -- and in both economic and noneconomic terms -- compelling enough for the executive to want to stay?
You can be sure each executive and key employee will ask themselves these questions, so if you want and need to retain them, you will need the answers as well. Every individual is different, so for those that are most critical to the deal, it is imperative to have their individual input and perspectives.
Of all these impediments to talent retention, some of the toughest problems stem from provisions found in the change-in-control agreements or, if none exist, in the equity plan. In particular, watch out for single-trigger change-in-control provisions, where the only thing that needs to happen to trigger the agreement is a change in control. Single-trigger provisions absolutely benefit the executive but may make it very hard to retain that executive, especially if it is a lucrative agreement and/or contains the full acceleration of all equity. Double-trigger provisions -- which only take effect when there is both a change in control and the executive is terminated -- are easier to deal with, for obvious reasons.
Even if the acquiring firm can retain the services of an executive who makes several million dollars on a change in control, it often has to reload the executive's equity, which may have a material impact on the shares available in the existing stock plan. If all option and restricted share grants within the company immediately vest upon a change in control, these create an even bigger problem in that there is no way to reload all employees with new equity grants given the current-day pressures not to dedicate too much of the company's equity to compensation. The existence of single-trigger change-in-control agreements and/or equity-vesting provisions within the stock plan that allow for full acceleration need to be very carefully weighed during the due diligence process.
Change-in-control agreements are not the only issue that can lead to significant integration difficulties. Increasingly, how the respective companies approach the use of equity and long-term incentives can also play a significant role in the retention of critical talent.
For example, assume a larger company with a 2% annual long-term incentive burn rate (e.g., using 2% of the shares outstanding on an annual basis to fund equity grants to executives and key employees) acquires a much smaller, higher-growth company where the average annual burn rate had been 5%.
The acquiring company simply cannot continue to grant shares to the acquired company executives and key employees at the rate they have been getting them and manage to achieve a 2% burn rate. What's more, those executives are now likely part of a division, rather than corporate officers, so the market-competitive grants will be much lower than historical levels. Thus there is likely a double impact -- significantly reduced participation in the long-term incentive grants and generally lower levels of grants for those that receive them.
How can acquirers clear these hurdles? We have found the following strategies to be effective:
- Identify the executives and employees you most need to retain and make sure they are well taken care of. Not everyone is equal, and when organizations try to take care of everyone, it is the top talent that often ends up paying the price. As they are the most marketable, it is these employees who pose the greatest retention threat. Leverage their rewards.
- Many organizations believe that they need to adhere to their normal long-term incentive grant levels even after acquiring a company. On the contrary: This is the time when exceptions to the norm can and should be made. Successful acquisitions require retaining key talent. Long-term incentives are an important tool here and should be used. Shareholders are more concerned about executives and key employees having a significant stake in the organization, so their interests are more aligned than they are with the expense associated with FAS123(R), the accounting statute that mandated stock-option expensing.
- Look at the total compensation package of newly acquired executives and key employees using tally sheets. It is critical to look at the entire package for your executives and to play this out into the future using several performance scenarios. This approach will enable you to look at your pay competitiveness in its entirety, to see how the new packages compare with what the executives had before the acquisition and to judge the potential value of those plans in the future. This will also enable you to communicate the new plan much more effectively.
Given the importance of human capital to the success of so many mergers and acquisitions, it's time to bring this issue to the forefront in both the due diligence process and in the very early stages of integrating two firms.
Organizations that address these issues early on face a much higher likelihood of either walking away from a potential bad marriage or of making the marriage work by retaining the talented people they need and having them fully engaged. - Jack Dolmat-Connell
Jack Dolmat-Connell (jackdc@dolmatconnell.com) is president of DolmatConnell & Partners Inc. and an expert in executive compensation. He works with organizations ranging from startups to Fortune 50 companies. He focuses on industries with intensive human capital needs, including high technology and life sciences. He also has special expertise in mergers, acquisitions and turnarounds.
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