What is a Retention Bonus and How Does it Work?

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An excerpt from Your Multimillion-Dollar Exit: The Entrepreneur’s Business Success(ion) Planner.

In many deals, retention bonuses are offered to key employees who are critical to the future success of the business. These bonuses become even more important if you are subject to an earnout based on the performance of the company after the acquisition. If a key employee leaves during the earnout period, they typically will forfeit all or part of the retention bonus. However, if they leave during the earnout period and haven’t been promised a retention bonus, there’s nothing for them to lose in leaving the company (unless they have equity in the new company).

The timing of retention bonuses is important. If you wait until just before closing to agree to these bonuses, it may appear that you must give the employees something to keep them with the company. If you enter into the agreement before the key employees know that the company is being sold (i.e., to show your appreciation for their loyalty and hard work), they may take a different view and appreciate the gesture. In any case, the bonus agreement should clearly state that no bonus is payable unless you close the transaction.

Retention bonuses sometimes are paid by the buyer and sometimes by the seller, and often the parties may agree to split the cost, depending upon the situation. The retention bonus payments might be staged over 12, 24, or 36 months. If the employee leaves voluntarily, dies, or becomes disabled during that time period, they will receive only the portion of the retention bonus earned before their termination and would give up the rest. If they are terminated without cause or leave with good reason, the entire retention bonus might be accelerated. If they are terminated with cause, they usually must forfeit the entire bonus.

These terms usually are defined in the retention bonus agreement and often heavily negotiated. Ideally, (if you are the seller) you want the buyer to pay the retention bonus; the buyer will want you to pay the bonus out of the total proceeds paid to you and the other owners in the transaction.

An Example:

You (the current business owner) offer a retention bonus to your employee of $300,000 to stay at the company after it is sold to the acquiring company. The acquiring company would promise to pay:

  • 1/3 at the end of 12 months,
  • an additional 1/3 at the end of 24 months, and
  • the remaining 1/3 paid at the end of 36 months of continuous employment.

If the employee leaves the company voluntarily after month 13, she would be entitled to receive 1/3 of the bonus but lose the remainder.

The employee will want to include provisions in the retention bonus agreement that require payment of the full bonus if the employer terminates the employee “without cause” or the employee leaves “with good reason”. These terms usually are defined in the retention bonus agreement or an employment agreement.

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