A company’s employees are frequently its most valuable asset. The talent that has built the business, developed the technology, served the customers, and created the operating processes that generate EBITDA is not automatically retained just because the business is sold. Buyers understand this, which is why employment and benefits due diligence is a standard and substantial component of every M&A transaction. For sellers, understanding what buyers examine in this area — and preparing for it — is critical both to protecting the transaction and to managing the concerns and expectations of key employees during what is often an unsettling time.

Key Employee Identification and Retention Risk

The first employment question every buyer asks is: who are the key employees, and will they stay after the acquisition? Key employees are those whose skills, relationships, or institutional knowledge are essential to the continued performance of the business. Depending on the nature of the company, they may include the CEO and leadership team, lead engineers or scientists, top salespeople, and customer relationship managers. The departure of any of these individuals post-closing could materially impair the business’s value.

Buyers assess retention risk by reviewing existing employment agreements, non-compete and non-solicitation arrangements, equity compensation packages, and the general terms of compensation for key employees. They will also want to assess the likelihood that key employees will be willing to work for the new owner under the new compensation structure that will be offered to them. In many transactions, the buyer’s offer to key employees is a condition to closing, or the buyer makes the execution of new employment agreements by key employees a requirement before the deal closes.

Sellers should think carefully about the retention question before the sale process begins and should consider what incentives — including transaction bonuses, enhanced equity acceleration, or retention arrangements — will be necessary to ensure that key employees are motivated to see the deal through to closing and to remain with the business post-closing. The cost of these retention arrangements is typically borne by the seller as a deal cost and should be factored into the seller’s net proceeds calculation.

Equity Plan Treatment at Closing

In companies with equity compensation plans — stock options, restricted stock, restricted stock units, or similar instruments — the treatment of outstanding equity awards at closing requires careful attention. The basic options are: accelerate all outstanding awards so they vest at closing (single-trigger acceleration), convert the awards into equivalent awards in the buyer’s equity (rollover), cash out the awards for their intrinsic value (the difference between the per-share merger consideration and the exercise price), or cancel the awards in exchange for replacement awards or cash retention arrangements.

The choice among these alternatives has tax, accounting, and motivational implications. Full acceleration at closing removes the post-closing retention incentive that vesting is designed to create, which may concern the buyer. Conversion to buyer equity may not be feasible if the buyer is a private company with no ready market for its equity. Cash-out is clean but may create taxable events and may also eliminate post-closing alignment. Buyers often prefer that outstanding awards be converted to time-based awards that vest over a new post-closing schedule, creating retention incentives that benefit the buyer’s integration objectives.

WARN Act Exposure

The federal Worker Adjustment and Retraining Notification (WARN) Act requires employers with 100 or more employees to provide 60 days’ advance written notice before conducting a plant closing or mass layoff. A plant closing is the permanent or temporary shutdown of a single site of employment that results in employment loss for 50 or more employees during a 30-day period. A mass layoff is a reduction in force at a single employment site that does not result in a plant closing but involves employment loss for at least 500 employees, or at least 50 employees if they constitute at least 33 percent of the workforce.

WARN Act analysis in M&A is relevant because post-closing integration frequently involves workforce reductions. If the buyer plans to eliminate positions, consolidate functions, or close facilities after closing, those post-closing employment actions may trigger WARN obligations. The threshold question is who is responsible for providing WARN notice and who bears liability for a WARN violation: the seller (for actions taken before closing) or the buyer (for actions taken after closing). The answer depends on whether the employment actions are taken as part of the acquisition itself or as part of post-closing integration decisions.

In asset deals, WARN Act liability for post-closing reductions is generally the buyer’s responsibility, because the buyer is the successor employer. In stock deals, the target company continues as the employer, and WARN compliance obligations remain with the company. Buyers often seek representations from sellers that no WARN-triggering events have occurred prior to closing and that no pre-closing commitments have been made that would require post-closing notification. Many states have enacted “mini-WARN” statutes with lower employee thresholds and additional requirements that must be analyzed alongside the federal law.

Benefits Plan Compliance

Employee benefits plans — including 401(k) retirement plans, health and welfare plans, flexible spending accounts, and executive deferred compensation arrangements — are a significant source of due diligence scrutiny and potential liability. Buyers examine benefits plans for compliance with ERISA (the Employee Retirement Income Security Act), the Internal Revenue Code, and the Affordable Care Act, among other applicable laws.

Common benefits compliance issues found in due diligence include: failure to timely remit employee 401(k) contributions to the plan trust (which constitutes a prohibited transaction under ERISA), late or missed plan amendments required to maintain tax-qualified status, ACA coverage mandates that have not been satisfied, Section 409A compliance issues in nonqualified deferred compensation plans, and inadequate documentation of plan administration. Any compliance failure identified during diligence is a potential indemnification exposure, and significant failures can result in plan disqualification or regulatory penalties.

Section 280G: Golden Parachute Analysis

Section 280G of the Internal Revenue Code imposes a 20 percent excise tax on “excess parachute payments” — compensation paid to certain key employees in connection with a change of control that exceeds a defined threshold. Section 4999 of the Code requires the employee to pay the excise tax, and Section 280G disallows the employer’s deduction for the excess parachute payments. The practical effect is that change of control compensation can be subject to double taxation: the employee pays ordinary income tax plus the 20 percent excise tax, and the employer loses its deduction.

280G analysis is a standard component of employment due diligence in any transaction that involves change of control compensation for executives, accelerated equity vesting, or severance payments tied to a change of control. Buyers require sellers to provide a detailed 280G analysis as part of due diligence, and the purchase agreement typically includes representations about the accuracy of that analysis and covenants about how 280G issues will be handled at or before closing. Private companies can avoid the 280G excise tax by obtaining shareholder approval of excess parachute payments under the Section 280G safe harbor, which is discussed in detail in a separate article on this website.

Understanding what acquirers examine in employment and benefits due diligence — and preparing for that scrutiny in advance — is essential for sellers who want to protect their deal from unexpected complications. Addressing retention risk, auditing equity plan documentation, reviewing benefits compliance, and commissioning a 280G analysis before the process begins are all investments that reduce deal risk and help ensure that the employment and benefits due diligence phase does not become a source of purchase price adjustment or deal uncertainty.