HR issues in M&A transactions
By Julia Jakobs and Dr. Martin Trayer, LL.M.
Surveys confirm that 80% of M&A experts consider employees to be key to the success of a transaction. 50% of transactions and transformation processes are said to fail because HR issues have been neglected.
Nevertheless, HR and labor law experts are often only involved late in the process. Sometimes the involvement of HR is even postponed until the integration phase following the closing of a deal. This may be far too late to bring in the HR perspective as deal parameters and milestones are often defined in the early stages of the M&A process:
Pre-agreements such as the Letter of Intent (LoI) or the Memorandum of Understanding (MoU) may already contain relevant HR decisions, e.g., on job or site guarantees or working conditions.
The scope of the HR or labor law due diligence decides on the quality of the information available to the HR department.
Findings from the due diligence process may or may not flow into the contractual agreements, e.g., in the form of guarantees given by the seller.
Overview of the M&A process
Timely involvement of HR is key to avoiding unpleasant surprises after closing. To this end, it is crucial to have an understanding of the M&A process and the potential pitfalls from a labor law and HR point of view.
Potential HR/labor law issues …
… in the preparation phase (phase 1)
Once a company has decided to either sell or acquire (part of) a business, the process usually starts with the submission of an indicative offer and the conclusion of pre-agreements (phase 1). Quite often, negotiations with the target’s management and/or key employees precede these pre-agreements to secure their support and loyalty during the process (and sometimes beyond). Typical measures include the offering of management incentives to support the deal, the conclusion of retention agreements to stay on board during the transaction, noncompetition agreements or exclusions of terminations during the transaction process as well as nondisclosure agreements (NDA).
Moreover, the deal parameter and transaction structure (share or asset deal) are often defined in the early stages of the transaction.
In a share deal, the employees remain employed with their current employer and individual and collective agreements generally remain unaffected. Any agreements between the employees in the scope of the transaction and other group companies (e.g., share-based remuneration agreements with the parent company) should be reviewed, however. The same applies to agreements providing for special termination rights in the event of a change of control. Moreover, the economic committee (Wirtschaftsausschuss) or, in its absence, the works council (Betriebsrat), if applicable, of the in-scope companies must be informed about the intended sale of shares.
An asset deal may be more complex as the business to be sold must be carved out of an existing organization. Transferring a business or part of a business by way of an asset deal may trigger a transfer of undertaking (Betriebsübergang) pursuant to section 613a German Civil Code (Bürgerliches Gesetzbuch, BGB) if the business or part thereof retains its identity after the transaction. Employees allocated to such a business are transferred by operation of law to the buyer. The buyer should review the list of transferring employees carefully: Are all employees identified by the seller fully allocated to the transferring business? If not, what criteria have been applied to identify the transferring employees? Are there any other employees (not allocated to the business) who are critical for the continuation of the business? Dismissal of transferring employees because of the transfer of undertaking is not permitted and cherry-picking of transferring employees is therefore not possible.
A proper review of the carve-out principles is all the more important since the buyer generally becomes liable for all outstanding obligations of the seller towards the transferring employees in a transfer of undertaking. These include outstanding salaries, credits on working time accounts or pension obligations.
If the buyer needs the current personnel to continue the business, safeguards should be put in place to ensure that a sufficient number of employees transfer to the buyer. In particular, the buyer should ensure that employees do not object to the transfer of their employment. In a transfer of undertaking, employees are entitled to object and remain employees of the seller, so a communication strategy should be in place to avoid objections.
While the works council has no statutory right to be involved in a transfer of undertaking, other measures taken in connection with the asset deal may trigger participation rights. These measures include potential reorganization or mass dismissal exercises. If such measures are planned, the seller may need to negotiate a balance of interests (Interessenausgleich) and social plan (Sozialplan) with the works council pursuant to section 111 German Works Constitution Act (Betriebsverfassungsgesetz, BetrVG). Negotiations with the works council may delay the process.
… in the due diligence phase (phase 2)
After the parties have agreed on the basic terms of the sale, the buyer will generally carry out due diligence. Labor law issues are usually covered by the legal due diligence, focusing on potential risks arising from labor agreements with individuals, the works councils or unions. Typically, the following aspects are the subject of labor law due diligence:
- Review of agreements with the management
- Review of individual employment agreements and collective agreements with works councils and unions
- Assessment of compliance issues, such as the findings of social security authorities or the correct treatment of temporary workers, freelancers and other contractors
- Assessment of ongoing and threatened labor law-related litigation
In addition to the standard scope of labor law due diligence, more detailed HR due diligence may be carried out. HR due diligence usually takes a broader view of employment issues including (hidden) personnel costs and accruals, stand-alone ability, HR organization and nonlegal issues such as cultural aspects or retention, for example:
- Analysis of potential retention measures for key employees
- Evaluation of (hidden) personnel costs and additional HR-related costs and accruals
- Evaluation of deal-related follow-up costs and potential risks for integration
- Analysis of remuneration system, in particular with respect to performance and retention aspects
- Analysis of relationship with works councils and trade unions
In general, the findings of the HR/labor law due diligence can be relevant for (i) the valuation, the business planning and the purchase price calculation, (ii) the drafting of the share purchase agreement (SPA) (e.g., warranties, guarantees, releases, covenants) or even be a deal breaker, i.e., high risk for the continuation of the complete transaction from a legal or financial point of view.
The findings of the labor law due diligence may include job or site guarantees, change-of-control clauses, post-contractual noncompetition provisions, etc. Furthermore, it may transpire during the HR due diligence that a number of key positions were vacant at the target company at the time the M&A process took place. The personnel costs may therefore not fully reflect the future costs for operating the business. Alternatively, a collective bargaining agreement (Haustarifvertrag) with the unions may provide for lower tariff rates than the industry standard due to the economic situation of the company. If a new investor takes over the business, the unions might claim the higher standard industry rates, which needs to be reflected in the business planning.
… in the execution phase (phase 3)
During the period between the signing of the purchase contract and closing the deal, the focus is usually on the closing conditions. If the parties have agreed that a condition for closing shall be that defined key employees will not terminate their employment with the target company, adequate retention agreements will need to be negotiated. Moreover, the buyer will start preparing for integration of the target company after closing to ensure day one readiness for all HR-related issues, e.g., payroll, management, reporting lines, organizational charts, etc. and set up a proper communication process (internally and externally).
HR-/labor law-related issues are relevant in each phase of the M&A process. In order to avoid being confronted with a fait accompli after signing the deal, HR should be involved early on and obtain all the relevant information during the due diligence process. Investing time and effort in the process pays dividends given that people are crucial to the success of a business.