David C. Strosnider: Executive Compensation and Governance in M&A

Craig Castelli:
Welcome to the Close M&A Podcast with Caber Hill Advisors. I’m your host, Craig Castelli. And today my guest is David Strosnider. David is a partner at the law firm McDonald Hopkins, a member of the Executive Compensation and Governance Practice Group. I think of him as a go-to resource for all matters related to executive compensation, benefits and employment law, especially in M&A transactions. So Dave, let’s jump right in. In most M&A deals, everybody thinks about the deal itself, a company selling to private equity or another company.That is the main transaction, but there really is a second parallel deal happening with the management team and that’s what we’re here to talk about. So just set the table and tell us about that second deal.

David Strosnider:
Yeah, so absolutely. Craig, thanks for having me. It’s always great seeing you. Usually we’re running into one another at a Widespread Panic concert, but today we’ll be talking about management team representation. So I’ve been practicing for 25 years solely in the exec comp area. We have a team of 17 professionals. They’re exec comp lawyers. We’re here in Chicago, Denver, Detroit, Cleveland, all throughout the US. We represent clients all throughout the US as well as folks that are coming in from Europe or coming in from South America. Primarily, 70% of our time is representing executives, which is not really the common thing. At large law firms, they’re representing the selling company, the buying company, the PE sponsors, that’s who they’re doing. But in our mind, we’re representing individuals that have a separation from service. We’re representing individuals that have a new employment opportunity. We’re really like sports agents, but we represent executives, not athletes.
One of the big parts of our practice is what we refer to as management team deals. So that’s representing sometimes just the CEO, sometimes it’s the CEO and the CFO, but sometimes I’ve represented a team that’s been 15, 16 people in a transaction. So as you said, everybody’s focused on the primary deal, selling the company, buying the company. But regardless of the transaction, whether it’s public to public, go private, private M&A, private equity to private equity, or private equity to strategic, there’s always a situation where these executives, these members of the senior leadership team have some serious things to think about and it could come down to what they’re going to receive in cash proceeds at closing, what rollover they’re going to be requested to ask to put into the deal, restricted covenants that bind them as well as the terms and conditions of their employment agreement to whom they’re reporting, what’s their role, what’s their scope? So in our mind, the management team representation is a big part of our practice. I think last year our team had more than 180 management team deals, just to give you an idea. And these are ranging from a hundred million dollars on the low end to we worked on a $35 billion deal last year. But as you can imagine, a lot of times you are the owner, you have significantly all of the equity, or maybe it’s a small ownership group and you might also work in the capacities and executive, but then there’s times where these individuals don’t have significant ownership, but they are a quintessential part of the deal on a go-forward basis. So that’s kind of the management team representation.

Craig Castelli:
And 100 million or 35 billion, it’s equally as personal to these individuals, I’m sure.

David Strosnider:
Absolutely. Absolutely. Really in my mind, a lot of practitioners say, well, if the transaction value is low, then it’s going to be an easy deal. And if the transaction value was high, it’s going to be a harder deal. And what we find is almost the exact opposite. So deal size is really important because it dictates the timing. So if it’s less than 126.4 million, there’s no requirement to get mandatory pre-merger notification from the DOJ or the FTC, which people call HSR filing. So a lot of times in those structures, what happens, those transactions is it’s a sign and contemporaneous close, so there’s no delay. In our other deals, certainly any deal that’s above $505 million, you trigger that regulatory HSR filing. And in those situations, what you have is you have a signing, certain documents are required to be signed at signing and then you have a delayed close, which runs anywhere from 30 to 60 days getting DOJ, FTC and other type of governmental clearance. So really the size of the deal dictates the timing and the process and the cadence.

Craig Castelli:
Yeah, I would say just from our perspective, independent of the regulatory aspect, there’s a certain base level of work that’s involved in every deal. And sometimes smaller deals just by virtue of the lower sophistication level of the company may be the more complex at the end of the day.

David Strosnider:
There’s always things when it’s a smaller company that you learn on due diligence that can be very problematic and difficult to unwind and cure before the closing. A lot of times when a company’s much larger, more sophisticated, maybe they’re public, a lot of times they have their compliance ducks in a row.

Craig Castelli:
Well, that company’s probably been through a couple transactions. Absolutely. At one point were at the stage of doing their first deal and uncovering some of those skeletons in the closet. Those management team members were going through their first transaction. By this point, the polish is there. But I mean, it brings up an interesting question because CEO especially, really any leadership, they’re usually integral in the sales running the deal, but you reach a point in the later stages of the process where the executives really need to sell their own company and that’s what they’re focused on. At some point that light bulb has to go off, “Oh, I need to start worrying about myself.” When do you start to see that mental shift?

David Strosnider:
Yeah, I think it should be early and often. So I don’t think it’s a on/off switch. I think it’s a dual process. So if you are the CEO, you have certain contractual obligations, you have certain fiduciary obligations to run the deal process to understand the deal process and to make sure that a good deal gets done. But at the same time, you should also be removing that hat as a fiduciary as an executive officer of the company and you need to start evaluating things from your own personal perspective because every executive has agency. So what am I being asked to sign? What restrictions are being placed on me? How am I interacting with my new boss? Because the buyer is the new boss. So you might’ve worked for years and years with the owner of the company and might have a very strong relationship. Now all of a sudden that company’s going to be sold. It’s not just your role, it’s not just contracts, but it’s culture, it’s what their perspective is on growth. It’s a lot of things, but my mind, it’s a dual process that should be constantly reviewed.

Craig Castelli:
How do you help them flesh out things like culture and views on growth? Because these first couple management meetings are bilateral sales pitches. Everybody’s saying the right things. Everything is great. No PE firm has ever lost a penny when they’re in management meeting. So I mean, I know what we do, and I’m happy speak to that, but I’ll ask you the question first. I’m curious how you help them think through those aspects.

David Strosnider:
So once we get engaged, we start looking at legacy documents, things that you’ve already signed. We start having an understanding of how the deal is structured, try to understand what your role is going to be with a company on the go forward. And then the most important thing is for us to determine by contacting buyer’s counsel like, “Hey, we represent Craig, he’s the CEO, we represent Jim, he’s the CFO. They’re going to be continuing on. What role do you see? Do you see it’s a continued role? Is there not going to be a lot of change from what it is that they currently do? ” And then when we start advising our clients about what they need to sign, what’s included in those documents, what we think is market, where we think they can push back a lot of times you learn about culture not during the cocktail or the dinner meetings or the pitch meetings in the office.
You learn when you start asking well thought out but difficult questions about your role in the organization. And as long as the client is informed, they understand what market is, we lead them through the process of how to help them negotiate the deal. So we’re not just legal scriveners that look at a document and mark it up. We like to lock arms with our executives early on. We like to help them think about things that they need to think about and present them to the buyer in a way that kind of makes sense, not emotional, but from business perspective, understanding what market is. And a lot of times you’ll learn the culture of the buyer during that process. Some buyers are very open to have discussions, they’re willing to listen, they hear you make a good request, simply react to it. In a situation where you’re bringing up points and you’re making a reasonable request and they constantly just say no. What I say to clients is if your partner is not listening to you in the honeymoon period, they’re not going to listen to you seven years into the marriage or on the verge of you becoming divorced. So let’s really figure out what’s going on at the beginning and seeing if this is a good match from a cultural perspective, from an alignment perspective of where the executive wants to go and where the buyer wants to go.

Craig Castelli:
Yeah. One thing you said there really resonates with a goal of ours in every deal, and it’s that A seller or a management team or both are going in with their eyes wide open. So let’s say we’re down to two strategics and one’s on its first round of private equity and one’s on its fourth about to go public. Well, you have wildly differences in the corporatocracy factor from one to the other. One’s going to be a little more nimble, a little more entrepreneurial and that comes with both pros and cons. Everybody thinks that’s better until you actually need to tap into the resources that are not yet built, whereas the bigger company is going to be a lot more stodgy, a lot more corporate. And you can flush that out even through some of the process that you’re describing in the bigger, more corporate buyer, you’re going to make a reasonable request. It may be a tough question, but it’s a reasonable request. And you’re going to watch it go through four different layers up and four different layers back before you get an answer and we’ll see how clear that game of telephone actually was. Whereas the smaller buyer, you may be dealing directly with the CEO and get an answer on that same phone call. And that’s just one of many examples. Each of those scenarios is going to be right for a certain person wrong for a certain person. And we want to just make sure that we’re arming our clients with information like that as well as what we can glean about culture, what we can glean about past performance, especially if it’s a PE. And then they can make the final decision themselves. Chances are the valuation is close and it’s these other factors that are really going to win the day when it’s all said and done.

David Strosnider:
Yeah. I would also say that when you have multiple stalking horses, the best deal is not necessarily the deal that’s providing the highest sale price. It’s the sophistication of the buyer, it’s the longevity of the buyer, it’s where the buyer is located. We’re working on a deal right now where it’s a US-based company and we have a French buyer and one of the nuances is trying to educate the French buyer on how things are done in the US. You go out with a Frenchman and you order frites, they’re putting mayonnaise on it. And if you put ketchup on it, they’re going to ask why. So when you have a sophisticated US-based PE firm or sophisticated private buyer who’s accustomed to what’s market in the US, sometimes it’s a little bit easier. There’s less requirement to educate the buyer on how things are or are not done. So that’s an interesting thing, but pretty much early on you can get an understanding of culture.

Craig Castelli:
Oh yeah. It just reminds me of a funny story where you talk about your Freets example. We did a number of deals with a Swiss buyer. This goes back a decade and they would always look at EBITA, not EBITDA. They didn’t factor depreciation whatsoever. At the end of the day, it was, are you going to pay a certain price or not and you’re going to win the deal or you’re going to lose the deal. But we had some funny early conversations where we’re trying to talk through one financial model and through their lens, it’s we don’t care about the depreciation at all. I want to jump into some of the more technical aspects of what you do, David, and go through some of the actual agreements that your clients are signing. I think it’d be interesting to talk about restrictive covenants, rollover agreements and management incentive pool grants, and then just the offer letters and employment agreements themselves. So we can start anywhere. I have restricted covenants on the top of my list, but take it as you want. Just take us through what are these agreements for the layperson and then what are really the big things that an entrepreneur or a key executive needs to understand?

David Strosnider:
Yeah, so let’s take it from the perspective of a deal that’s large enough where there’s a sign and a delayed close. Typically, the process is two documents get signed at signing. One is a sale restricted covenant agreement and one is either a rollover commitment letter or the actual long form rollover documents. And then typically what they do is they also prepare a binding term sheet and they affix that to the sale RCA and that binding term sheet relates to what we call governance issues, things that should be or will be included in either the limited liability company agreement or the limited partnership agreement and will govern not only your rollover equity, it could govern the equity that you receive if you’re making an after tax investment and then it also governs the incentive equity on a go- forward basis. So that term sheet really goes through conversations on whether the client’s going to be a member of the board, whether it’s just the operating company board or the parent board. It can go through call mechanics, call right mechanics, put mechanics, drag alongs, tag alongs, restricted covenants that are built into those agreements. But typically that’s the process we see when it’s a sign and delayed close. So the first document is the sale RCA. If you have equity in a company and it’s being redeemed as part of the transaction, or if you don’t, but you’re getting substantial kind of bonus proceeds like a sale bonus, nine times out of 10, the buyer’s going to be requesting you as the recipient of those large funds to sign a sale RCA. We in our group refer to it as a burndown RCA because the way that this works, it’s unlike other restricted covenants and employment agreements or equity documents. We call it a burndown because at the day of closing that candle gets lit and then that candle runs for a specific period of time, usually markets three to five years. And at the end of that fear period, the candle burns out and it’s no longer applicable. So it has nothing to do with whether you’re in the employ of the company or not, it’s from closing. And that’s a document, whether it’s PE to PE, whether it’s a private M&A transaction, whether it’s strategic, a lot of times that’s where you have a lot of opportunity to make some changes. So the important thing there is you’re taking a snapshot of what the business does at closing, not what they may do in the future, but at closing. You’re looking at the duration, should it be three years? Should it be five years? What’s the quantum of what it is that the individual’s receiving from sale of the equity or the bonus? And then what we do is we go through that document and we kind of narrow the scope of the definition of business. We try to narrow the restricted period, but most importantly, we include a lot of carve-outs in the non-compete. We put carve-outs in the non-solicitation of employees. We put carve-outs with regard to confidentiality. A lot of times when you receive equity on a go-forward basis, they’re going to require your spouse to sign a spousal consent that she or he have read the limited partnership agreement, that they understand it, that they know that these units are subject to transfer. And the idea is they don’t want divorced spouses to claim that this is now part of the marital estate. So the sale RCA is a big lift at what is the beginning of the transaction, a lot of times it sets the table for how the buyer’s looking at restricted covenants and the carve-outs associated there with. But big document there. I think that the second document is either a rollover commitment letter, I, Craig, hereby agree that I will roll over 30% of my equity or 30% of my bonus. Typically, we like that structured as tax deferred.

Craig Castelli:
And is that a binding commitment?

David Strosnider:
Yeah, binding commitment. Binding commitment as long as the deal closes.
And at that time we bring in our… you know, I’m a tax attorney, but we bring in traditional tax attorneys. They’re looking at the purchase agreement, they’re looking at the partnership law mechanics, they’re making sure that it can be effectuated on a tax deferred basis based on how they’re structuring it. But the most important thing is we’re really looking at this term sheet. We’re making sure that we build in things that will not be there when we see it first. So information rights is a huge thing. The call mechanic, to the extent that they exercise the call, do they have to pay it in cash? Can they give you a promissory note? Is the promissory note only limited to the extent that there’s a potential breach of a debt covenant? What period of time that promissory note can be repaid? So there’s a lot of things that wind up flowing into that governing document, the LPA and the LLCA.
And at the time of signing, it’s really memorialized in a robust term sheet. Once you have those things done and it’s signed, now you’re pushing from signing to closing and the big tickets are actually reviewing the limited partnership agreement document to make sure that it’s consistent with a term sheet, negotiating those things that weren’t covered by the term sheet or it’s a gray area and then ultimately handling either an offer letter, an offer letter on steroids or an employment agreement, as well as the underlying what we call MIP award agreement. Now, usually as you know, when it’s PE, it is a profits interest because they use partnership mechanics. If it’s a strategic, a lot of times what we’ll see is straightforward options. In public, it’s usually RSU, PSUs or options, but addressing things to figure out what’s going to happen on a go-forward basis and to make sure that the terms and conditions associated with that is market and pushing where we can in a strategic and calm and business-like manner is really the goal.

Craig Castelli:
Should somebody be overly concerned when the term sheet and the actual definitive documents have a disconnect, or is that more likely a drafting error rather than any sort of ill will or devious intent?

David Strosnider:
Yeah, so quite frankly, it can be both. It can be both. And you don’t really know until you start doing the dance, how good your dance partner is. Sometimes they just don’t address it. Sometimes they make a mistake. Sometimes they think it’s open to further negotiation. But again, the term sheet is the architect plan. We’re figuring out does Craig and Shannon want a single family home or do they want a condo? If they have a single family home, do they want it to be a ranch? Do they want it to be two stories? If it’s two stories, do they want their primary bedroom on the first floor and do they want it on the second floor? Do they want land? Do they not want land? They want it be based in an urban setting. So there’s a lot that we try to flesh out in the term sheet. Obviously it can’t address everything, but then I think it’s really up to good faith negotiation between counsel for management and counsel for buyer to land in a good place because these are the folks that are going to continue to run the company. These are the folks that are being asked to sell the company five to seven years into the future. So it should be viewed as a partnership. It should be viewed as the management team is joining, they’re locking arms, they’re going to be a partner, they’re all aligned on what they want to do with a company on a go forward basis.

Craig Castelli:
Yeah, I find that this is one of the areas where I’m most frequently talking to client off the ledge. I see it more as we go from LOI to purchase agreement and those documents more so than I directly see it in the employment related documents. But same concept applies where we agree to a structure in document A and it’s totally different when we move to document B. And what most likely happened is that there was just poor communication between the parties drafting one versus the other and we get it fixed. But immediately our entrepreneur clients especially jump to the worst case scenario. What games are they playing? What are they trying to pull? And I mean, there’s never really a good excuse for it. Everyone should just have their act together and keep things consistent all the way through. But the reality is you do have to play these games. It is a game, it is a dance and you have to just prepare yourself to go through some of this.

David Strosnider:
Yeah. So in law school, they have a saying that an attorney that represents himself as a fool for a client. I think you know my background is I’m half German and I’m half Italian. So when I’m negotiating on behalf of my clients in the senior management team, I’m calm, I’m cool, I’m collected, pragmatic, not emotional. When I negotiate on my own behalf or my wife’s behalf, I’m Italian. I’m emotional what’s happening. They’re not living it up to their side of the bargain. So a big part of what we do is we serve as an advisor, a consultant, a psychologist to make sure you as the executive don’t go on tilt. We want to make sure you say, “You know what? Until we know let’s pretend that this was not the buyer directing them to do this. Let me connect with buyer’s counsel. Let me talk to them about the issue. Let me see if this is really in alignment with what the client wants them to do. Let’s have an open discussion.” So I try to keep things as unemotional as possible because I understand that the CEO is not only running the deal on behalf of the equity holders in the company, but they’re also running a deal on behalf of themselves and more importantly, their senior management team. Because what they agree to with the MIP, the pool, the breakdown between time vesting and performance vesting, the repurchase mechanics, the restricted covenants that are built into those documents, you ultimately are going to have to go and sell that program as the CEO to the other members of the C-suite as well as to the individuals who are SVPs and below. So you need to understand what they’re thinking about. You need to have an understanding of the program, not just for your own economic benefit or your own career benefit, but you’re now utilizing that program to attract, incentivize and retain top level talent to the exit on the next turn.

Craig Castelli:
That’s a really good point because for that CEO, there’s probably millions of dollars at stake. And for every level at which these plans apply, it is likely a meaningful amount of money for everybody involved relative to their current compensation, historical compensation. And if that CEO thinks he’s getting screwed and then goes out there and delivers a message colored by that mindset, you probably scare some talent off. You probably make it harder to grow that business. You probably make it that much harder to actually earn those dollars when all is said and done.

David Strosnider:
Yeah. I mean, when you’ve changed jobs outside of the transaction environment, you get called by a recruiter, you get called by a potential employer, you tell them, “I have no interest in leaving.” They continue to push. You have conversations, you start liking them, you move down the process, you really are in the driver’s seat. When you’re an executive and you don’t have substantial ownership in the company, you’re not in the driver’s seat. A lot of times the seller’s like, “Hey, I’m Craig. I own a hundred percent of my company. I’m selling it. I’m good with the $250 million purchase price and that’s what needs to be done in order for the deal to get done.” But you’re not necessarily looking down on how other people are going to react to the fact that they now have a new employer and they didn’t decide that they wanted to leave and they didn’t decide that they wanted to go work here and they weren’t really sure about the culture or the individual’s experience in the area or what their growth or business perspective is. So it’s always nuanced. Every one of these deals is specifically nuanced. And what happens is we just see so many different transactions that we start getting a feeling about what is and what is not important. So again, when a lot of lawyers come on the phone and they talk to you about the law and you get tired. So what we do is we focus on materiality, probability, leverage and risk. We talk to our clients about that. I talk to the members of my team about it and the idea is that if the materiality is you pushing a penny across the table or the probability is the same of you and I visiting Mars in our lifetime, it doesn’t matter what the legality is. So that’s where we try to keep our clients’ head.

Craig Castelli:
So what’s the landscape today? Have things shifted at all in recent months or years, either in the favor of the employee or in the favor of the employer in these negotiations?

David Strosnider:
Yeah, it’s really different every time. It’s really different every time. Sometimes our clients have significant leverage, usually in a PE to PE, what we call platform deal, the management members have the most leverage. If it’s a strategic deal and your company is being purchased by the 900 pound gorilla and they have 30,000 employees, a lot of times what they say is, “Craig, we can’t make a revision to this offer letter. This is the same offer letter that’s used by every single employee that we have in our public company or every single employee that we have in our private company. And if we make a change just for you, then think about the administrative burden it’s going to be for us to track all of those custom and bespoke agreements. So again, the sale RCA is not one of those documents and that’s really where you have the opportunity to gain some ground. But the leverage is different. Each deal is different. Sometimes we do management team deals and it’s clear that the buyer wants every single member of management to stay. Not only stay once the closing has occurred, but stay through the next turn of the transaction. Other times it’s kind of clear at the beginning of the negotiation that the buyer, quite frankly, just doesn’t care because they may have their own CEO or their own CFO that they immediately want to replace. So every negotiation is nuanced and it’s picking up both the client and us as counsel on what those tells are and quite frankly, acting appropriately.

Craig Castelli:
Well, David, this has been very insightful on a lot of topics. I think we’ve covered a lot of ground here. If somebody listening wants to get ahold of you or learn more about your firm, where should they go?

David Strosnider:
Yeah, so on my bio under representative cases, I have a good kind of what I call deal sheet. I’m not naming individuals, I’m not naming the companies, but you can read that and get a flavor for what we do. I always am happy to speak to people on the phone. Absolutely. I always provide time to see if the relationship is a good one for both of us, see if there’s a real opportunity for me to help. Law is a business, but I view it also as a profession. And more importantly, the professional aspects of my practice are sometimes more important to me. So we’re acting as fiduciaries. And as a fiduciary, I’m putting the client’s interest ahead of mine at all time. And there’s sometimes where I’ll tell a client, “Hey, I don’t really think that you need me.” Or I’ll say, “No, I absolutely think that you need me.” But that’s kind of our focus. We have a broad team. All of us love what we do. We think we’re good at it, but contacting me via email, happy to respond, happy to have a conversation and happy to explore the own unique circumstances of the transaction and how management fits into it.

Craig Castelli:
So you can find his bio and all the information he’s referencing at mcdonaldhopkins.com. I can definitely vouch for everything he said. He’s very responsive every time I’ve introduced him to executives and always received good feedback, whether there was a need or not coming out of those conversations. So thank you for that and thank you for joining me here and thanks everyone for watching us on The Close.

David Strosnider:
All right, Craig, thanks a bunch for having me. I appreciate it.