Red L&E Flags In M&A Transactions


4 minute read

Red L&E Flags In M&A Transactions

Whether you are a buyer who wants to evaluate a target business, or a business owner planning to grow your business and sell it down the road, you should keep in mind that HR-related issues arising during the due diligence process can have a great impact the purchase price, indemnities, and hold-backs — or even whether the deal closes at all.

The following are some of the most common issues that arise in evaluating a transaction:

  1. Misclassification of workers as exempt. Are employees properly classified as exempt or non-exempt from the minimum wage and overtime requirements of the federal Fair Labor Standards Act (FLSA)? It is a common misconception that employees paid on a salaried basis are never entitled to overtime pay. In reality, there are a number of questions that must be answered, beyond whether an employee receives a salary rather than an hourly wage, when determining whether the employee can be properly classified as exempt from the FLSA’s overtime requirements. The nature of the employee’s duties (not just in a job description but in actual practice) also must qualify the employee for an exemption. If employees are misclassified as exempt, the business may be subject to liability for unpaid overtime wages, double damages, and attorneys’ fees. There is a two-year look-back for these types of claims, which increases to three years if violations are considered willful, and a purchaser may be subject to liability as a successor to the seller’s business.
  2. Lack of protection for business relationships. Have reasonable steps been taken to protect business relationships? For example, were employees required to sign restrictive covenant agreements and given adequate consideration for signing? (In many states, mere employment or continued employment at the time of signing may not be enough to justify the restrictions unless such employment is for a significant duration after signing.) Are the covenants reasonably tailored to pass scrutiny under applicable state law? If not, will the law permit a court to reduce their scope? These are important issues, particularly when the value of a business is largely derived from its customer relationships.
  3. Lack of protection for confidential information and trade secrets. Has the business also implemented measures designed to protect confidential information and trade secrets? Having employees sign a non- disclosure agreement is not enough. An employer also must take adequate steps to protect its valuable information in order for such information to be deemed protectable if litigation ensues. This is an important issue when the value of a business is largely derived from its secret sauce.
  4. Misclassification of employees as independent contractors. Are workers routinely classified as independent contractors? If so, is this classification proper? Several government agencies, including the IRS, the U.S. Department of Labor, and state agencies responsible for administering unemployment benefits, scrutinize such classifications. Improperly classifying employees as independent contractors can subject a business to liability for several years of unpaid wages, unpaid taxes (including unemployment contributions), interest, and penalties.
  5. WARN Act liability. Has the business closed any facilities or implemented any mass layoffs? Depending on the number of affected employees, the business may have been required to comply with the notice requirements under the federal Worker Adjustment and Retraining Notification Act (WARN Act) or applicable state mini-WARN acts. Remedies for violations of the WARN Act include payment to aggrieved employees of back pay and benefits for each day of the violation, i.e. the period in which notice was required but not given, up to 60 days; payment of government penalties of $500 for each day of the violation; and attorneys’ fees.

Severance pay obligations. Did the business enter into employment agreements containing rich severance obligations triggered by a change of control? If so, the parties should assess up front whether the employee will be retained following closing, whether the employee’s employment terms following the closing will be comparable to those he/she enjoyed while in the seller’s employ, and if the severance obligation is triggered, which party will be obligated to satisfy it.

Naturally, every business combination is unique, and due diligence must be conducted on a transaction by-transaction basis. However, the issues described above are among those that can cause significant heartburn. Whether you are a buyer who wants to get the value you are paying for, or a seller who does not want to be saddled with a large indemnity obligation or a purchase price hold-back for contingent liabilities, these are issues worthy of attention.