Stephen Ravenscroft
- Partner
- Employment
Part 2 – Business of Succession: Success and employment law strategies when selling a business
We continue our conversation with Employment partner Stephen Ravenscroft for our Business of Succession campaign. Steve shares his expertise on the employment law aspects that founders need to consider when taking investment or selling up.
In the world we live in today, founders don’t all look the same. You can have a founder who started their business in their bedroom at 16 and somebody who’s been running a business for the last 45 years. How often do you see discrimination possibly play a part in an exit?
I only really see the risk of discrimination arising where there has been a fallout, and no investor really wants that to happen, because they’ve put their money there to grow it with the people whom they have backed. But there can be things that people don’t expect.
For example, there can be ill health, which could constitute a “disability”; or there could be issues in somebody’s family that take a focus away from the business for perfectly understandable reasons. So, discrimination issues do arise from time to time.
From an age discrimination perspective, an investor may expect the founder to engage in retirement and succession planning if it is likely that the founder may not remain actively involved in the business for the anticipated duration of the investment, and if the founder doesn’t want to let go, those kind of issues that can create a clash, but I would say that the investor will almost always be looking for the business solution.
Of course, sometimes, that business solution has to take into account the personal circumstances of an individual and how to accommodate those, or how to address them in a legally compliant way.
Let’s look at the investor’s perspective. Is there anything that you would say they need to be particularly sensitive to and careful of?
I expect that most investors look at the metrics first. They look at the business, they look at the sector and they look at all of the financials.
They also look at the people. Ultimately, the investor will need to decide if they want to back the founder and their management team as the people entrusted to continue to grow the business. That sometimes means that, at a very early investment stage, the investor may say, “you’ve got great people, but you haven’t got the right structures in place to maximise their potential”, or “you’ve got lots of people who are great at what they do, but they don’t really understand the division of duties and they don’t understand the common goal”.
In addition, there may be functions of the business that in the early stages just weren’t possible to invest heavily in, like HR, marketing, maybe some of the tech and the IT aspects of a business. So, an investor may come along and say, “what you’ve got here is great, but we need to bolster these areas of the business with some more key personnel”.
It may be a case that either the company doesn’t have the right people internally, or the people who are already there need better training and development to be able to perform their roles. There will normally be positive conversations around the theme of improving the skillset of employees.
Of course, there can be some tough decisions around not having the right people or letting certain people go. The investor and the founder should be able to have very frank conversations about this, because it’s in both parties’ interest to make sure that the business is a success going forward. There may be some sensitivity in a founder accepting that, when the investor invests in the business, what’s made it successful up to that point isn’t necessarily what’s going to make it successful going forward. The people strategy may be a part of that change.
The more the founder and the investor are able to discuss openly and plan for the success of the business based on the personnel they need going forward, the better.
Once you’ve got that right team in place, and identified, what can founders and investors do to ensure that you can keep that team together?
There are two ways of doing that. There’s the stick and the carrot.
The carrot, which is going to be absolutely vital, is having the key personnel participating in some way in the success of the company going forward. Now, that may mean that alongside the founder, there’ll be other members of the management team who will participate in the equity of the business, possibly in some type of management incentive plan. And then maybe a separate employee share option plan for other managers and personnel who are seen to be really important to the future of the business.
These plans would have triggers, including exit events, upon which the participant receives value for their holdings, and it would normally be a requirement that they remain employed (or are treated as “good leavers”) in order to benefit from such an event. Indeed, some plans retain the ability to recharacterize a “good leaver” as a “bad leaver” if they undertake competitive activity within a specified period after leaving employment.
Making sure that you have the correct levels of incentivisation in place for the right people is going to be absolutely critical.
The stick option revolves around the types of restrictive covenants that you would want in place in new employment contracts, for example non-competition, non-solicitation, non-poaching and so on. And there would probably be similar, often more onerous, restrictions in any SPA, SHA and/or IA which would apply to the founder as well as other senior individuals.
Indeed, it may well be that in the SPA/SHA/IA, the founder is subject to quite long restrictive covenants; if it’s a sale of the business, the covenants often run from the date of sale for a period of three to five years, or if they’re retaining equity then they may run from the date that they cease to be a shareholder for, say, a period of 12 months but even up to two years. Any such restrictions would, of course, be subject to the normal common law tests as to their enforceability. These are going to be key issues for any investor to make sure that the key people are properly incentivized, but if they choose to leave, there are some defences up against competitive activity going forward.
That’s going to be a key issue for the founder too. You often think of founders selling their business as a kind of runway to retirement – they may not be that bothered about restrictive covenants and competitive activity because that’s not what they’re thinking of once they have sold. But there are plenty of other founders who, as soon as they have sold, are thinking about the next thing, what am I going to move on to? And if that’s somewhere within the sector that they’ve currently been operating in, then understandably an investor or a buyer will want to protect against that.
It’s an area that any founder and any management team will need to take legal advice on to make sure that they understand not only the consequences of being a “good leaver” or “bad leaver” on their equity, but what actually applies to them when they leave in terms of their ability to continue careers, grow new businesses and start up employment elsewhere.
Find part one here.
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