Caveat Emptor – The Hidden Cost of Inherited Employees when Buying a Business

Some months ago, a client – “Darlene” – was exploring buying out / merging her business (Company A) with a competitor business (Company B). Darlene initially requested that we provide an independent perspective on the fair market valuation of Company B. We performed due diligence, requesting, testing and validating the data provided by Company B’s owner-manager, who was eager to consummate the transaction so that they could retire. This data was then used to form a value opinion based on our understanding of the value of Company B’s assets (what it owns), its liabilities (what it owes) and its earning capacity relative to operating risk.

Darlene spoke confidently of the upside potential of the transaction. She saw an opportunity to ‘increase market share’ and ‘find efficiencies’ from the merged entities. She indicated that she anticipated retaining most of the employees. In any case, she made it clear that the employees joining from Company B would have to sign new contracts with the merged entity. She also made clear that employees both from Company A and Company B would be required to adjust to new roles with new responsibilities as well as changes to working hours and other work conditions.

At this point, we felt compelled to provide additional advisory assistance to Darlene. Her assessment of the transaction had failed to consider the impact of employee redundancy obligations inherited with Company B. Note - text from the relevant portions of the Employment Act 2000 is highlighted below.

• “Where a business is sold, transferred or otherwise disposed of, the period of employment with the former employer shall be deemed to constitute a single period of employment with the successor employer, if the employment was not terminated and severance pay was not paid...”

• “… on termination of his employment, an employee who has completed at least one year of continuous employment shall be entitled to be paid severance allowance by his employer.”

• “… termination of employment means termination by reason of (a) redundancy; (b) the winding up or insolvency of an employer…”

• “… the amount of severance allowance payable to an employee shall be no less than the equivalent of (a) two weeks wages, for each completed year of continuous employment up to the first ten years; (b) three weeks wages for each completed year of continuous employment thereafter; up to a maximum of 26 weeks wages.”

• “… Severance allowance is not payable where an employee unreasonably refuses to accept an offer of re-employment by the employer at the same place of work under no less favourable terms than he was employed immediately prior to the termination”

What Darlene had missed was that with every employee who had accumulated 12 years or more of ‘continuous employment’, she would have an obligation to pay them half a year’s wages in redundancy – even if almost all of that employment had been accumulated with the acquired company. If the employees refused to accept new positions / responsibilities which were judged to be less favourable, she might also be exposed to this obligation. Even if she ‘threw in the towel’ and decided to wind up the Company, the obligation would remain.

In addition to being aware of the potential for inherited severance obligations when purchasing a business, other best practices include:

• Maintain and fund a separate bank account for severance obligations, with adjustments made on an annual or semi-annual basis to account for new hires, retirements, etc.

• Consider redundancy obligations when evaluating employee compensation structure. For employees who have performed well, it may be appropriate to first consider discretionary bonuses (which are excluded from severance calculations) as a reward, while taking a more measured approach to pay increases.

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