Big Deal Small Business: Key Employees in SMB
October 28, 2021 | Issue #48
Today’s post is more of an open-ended discussion prompt. I’ll cross-post it over to Twitter as well to see what people have to say. Feel free to send responses by replying to this email or on a Twitter thread I started.
Everybody knows that people are the core of any business, small or large.
That said, in the large businesses that I focus on in private equity, there’s generally not a single key employee that the business won’t survive losing.
In a sense, the transition from small to large business requires the systemization of processes that make any given person (including the owner or CEO) less important.
As a result, in large businesses, culture tends to be more crucial as it determines how people interact with the business (current employees, former employees, and potential candidates).
But in small businesses, you need the culture component but can STILL have massive key employee risk. That’s a scary reality for searchers to grapple with, especially coming from PE where I’m not used to seeing that risk in my deals.
So how do we deal with this during due diligence?
Below I share an anecdote that prompted this newsletter, and then a couple discussion questions.
If you’ve got thoughts/answers to those questions, I’d appreciate email responses or comments on Twitter – I’ll collate those and send around to the full chain next week.
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GM Quits During DD
A few months ago I was getting excited about a exterior home services business that had a great org chart in place. In particular, it had a well-paid GM who seemed like a real go-getter and well-incentivized to grow the business (had a % of gross margin comp plan).
As a first-time operator, the prospect of having a GM in the business on day one was super enticing. He knew about the sale as well, so I'd be able to meet him later in the DD process.
I progressed through the IOI stage and we were hurtling towards an LOI. The brokers & seller suggested I come out to meet in-person and tour the business & market.
I spent the whole day with the seller driving the market, looking at projects they've done, etc.
Somewhat randomly, about 3-4 hours into the day, I asked the seller about the GM's thoughts on the sale process.
Very casually, the seller tells me the GM quit the week prior.
I tried to disguise my shock as the seller explained how stressed out the GM was, how he wanted more money, how he ended up going to another competitor where he could have a smaller job with better work/life balance.
I ended up killing that deal over employee churn -- the GM leaving was just the cherry on top; there had been a string of employee turnover (at the office staff level, not just crew level).
But the lingering thought I haven't been able to shake for months:
What if the seller incentivized a key employee to just stick around through Closing? I got lucky that this GM quit during DD. The seller could have paid him a transaction bonus to just wait around a couple months and then quit the day after we closed.
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Discussion Questions
How do you define a "key employee"? The reality is any business with ~10 office staff, you can probably define at least one employee (if not more) as crucial. So what does it take for an employee to cross the line into being a material risk to diligence?
What kinds of key employees are you willing to take a risk on versus not? For example, the operations manager who makes the trains run on time vs the top saleswoman who owns a large customer relationship.
Do you insist on meeting key employees during the DD process? Sellers are generally very hesitant around this, so would love your views on what you can & cannot live with in terms of employee access.
How do you do your due diligence on key employees and the risk that they leave, along with what you'd do to replace them? Very broad, open-ended question, I know, but would love your thoughts.
How do you like to construct retention packages or communicate vision to help retain those employees? Money isn't everything, so a key factor is understanding what drives the specific person. But how do you go about doing that?
I put all these in a Twitter thread, so you can reply over there too:
Conclusion
If you have thoughts on any or all of the above discussion prompts, I'd welcome your feedback.
Assuming I get some reader responses, I'll collate and post back to the group next week. If there's anything you want to send me that you also want me to exclude in the public post, just let me know of course.
Looking forward to hearing your thoughts! Hit reply to this email or find me on Twitter.
Thanks,
Guesswork Investing
P.S. I’d always appreciate introductions to potential acquisition targets or brokers (primarily targeting $750K-$1.5M+ of SDE or EBITDA, located in Seattle or the Bay Area).