Written by Thédoor Melchers. 

Management Incentive
To motivate and reward key managers, an “incentive plan” is often set up. This lets key managers benefit from the company's increase in value. When the company is sold, key managers thus receive a portion of the proceeds.

In a sale, it is important for the shareholder selling the company to realize that the interests of key managers and the shareholder(s) do not always coincide. A management incentive plan, which aims to create a joint interest in value creation of the company, can create a conflict of interest in a sale where key management reinvests har sale proceeds into the Buyer.


Reinvestment Key Management
When a key manager acquires an interest in the Buyer through shares, certificates, options or a SAR as part of a sale process (hereinafter: Reinvestment), this key manager may have an interest in a lower sale price. After all, a key manager whose equity interest increases in a Rollover benefits from a lower purchase price for the company being sold. For example, a key manager with a 5% interest as Seller, who obtains 10% as Buyer in a Reinvestment, needs to invest two euros less as Buyer for every one euro less purchase price he receives (as Seller). This interest is further reinforced if a envy-ratio is offered to the key manager by the Buyer. Here the interest of the key manager clearly differs from the interest of the shareholder selling the company, and this must be handled carefully.

We advise Sellers to protect against the scenario outlined above in a sales process, including in the transaction documentation (confidentiality statement/term sheet/offer letter).

When multiple interested Buyers have come forward for a business, it is wise to share only the amount of the highest bid with the key management reinvesting, to avoid the temptation that might arise with key management to inform the Buyer of the “second highest bid.

When Buyer is aware of the “second highest bid” in the process, this information gives Buyer a strategic advantage in negotiations with Seller on the “bridge from corporate to shareholder value,” resulting in the final purchase price.

It is inevitable that the Buyer will talk to key management at some point during the sales process, and in such a conversation such information is quickly shared.


Knowledge and guarantees
When the selling shareholder was not involved in the day-to-day operations of the company, the knowledge of key management determines the duty of disclosure that a Seller must meet in the sales process.

A key manager who reinvests and remains involved in the business after the transfer of the business is usually contractually obligated by the Buyer to share with the Buyer any warranty breach of which he has knowledge after the transfer. Given the key manager's involvement in day-to-day operations, he is more likely to be aware of a warranty breach than the Buyer who serves as a shareholder and is therefore less actively involved in day-to-day operations. This is especially true for private equity parties who purchase a company but do not join as directors in the purchased company.

The purchase agreement does not distinguish between facts and circumstances that came to the key manager's knowledge after the time of delivery of the company and facts and circumstances that the key manager already knew or should have known at the time of the conclusion of the purchase agreement, but only realized after the transaction. Making such a distinction encounters practical difficulties since it involves information that is in the key manager's head.

Should the Seller indeed have to pay damages to the Buyer because of a warranty breach in the purchase agreement, the key manager in the above example pays 5% as Seller, but benefits 10% as Buyer.

The usual provision in the purchase agreement in which the buyer declares at the time of delivery that he is not aware of possible warranty breaches (anti-sandbagging provision), does not help the Seller here. Moreover, if the transaction structure involves a purchase vehicle that has been capitalized by the Buyer and a bank specifically for the transaction (the “bidco”), it is highly questionable what knowledge from the book review should be attributed to this purchase vehicle. This is because the purchase vehicle is often set up shortly before the time of transfer, which can give rise to discussions about the knowledge that this purchase vehicle has at its disposal at the time of delivery of the shares.

Regardless of the issue of Reinvestment by key managers, it is important to specifically define in the purchase agreement what knowledge is attributable to the purchase vehicle so that no breach of warranty can be claimed by Buyer.