What’s a Golden Parachute (And How It’s Used in M&A)
Do you have a golden parachute?
There can only be three answers to this question. “Yes,” “No” or “I don’t know.”
The first two answers are clear enough. But if your answer is “I don’t know,” then you most likely don’t have one.
Just like a normal parachute, a golden parachute is meant to provide you with safety.
However, it’s not a normal parachute which happens to be made of gold. Or gold plated. Or gold colored.
A golden parachute is simply an agreement. More precisely, it is a clause in an employment contract or agreement.
Unlike the other clauses, more commonly referred to as the terms of employment, a golden parachute has a unique purpose.
Also, it’s only in the contracts of certain employees and not all.
In any case, isn’t the nature of gold such that you can’t find it everywhere?
Golden parachutes are the preserve of top executives in big companies, especially CEOs. In some cases, the companies may not necessarily be big, but may be operating in highly-competitive environments or industries.
The clause lists the benefits which a top executive should receive from an employer in the event of termination of employment.
Though there can be different reasons for termination, a major reason envisioned when drafting these clauses is a merger or acquisition.
This is the case because during mergers and acquisitions, the control of the company usually changes.
When a new company takes over your company, rarely will the top management be left intact.
The person or company taking over your company will have a preferred way of doing things.
A different way of running the company will mean a new set of managers, especially at the top. Different decisions have to be made going forward.
Whereas this is good for the individuals being entrusted with the running of the company, it is bad news for the leaving executives. To them, they have lost a job. Losing a job is not easy.
Lacking a sustainable source of income affects your life. Unless you had planned for it accordingly.
One characteristic of the top position in a company is risk taking. Top managers are employed to make the hard decisions and take (calculated) risks.
Being human, they could make decisions which end up being big mistakes. These could lead to huge losses, or even a shutdown.
Such results often lead to job loss.
This makes top executives afraid of making some decisions because they are afraid of the repercussions in case things don’t go well.
But their indecision is also a potential loss of great opportunities.
Top managers are people who flourish as risk takers.
But if they are faced with difficult choices between taking a risk and losing their jobs, it is obvious which one they will go for.
To enable the manager feel comfortable and free to make the decisions he needs to make, a generous perk is provided to cushion him in case he gets terminated.
Golden Parachute vs. Golden Handshake
Another common term, perhaps more common than the golden parachute, is the golden handshake.
Although both the parachute and the handshake are golden, there is a difference.
Whereas a golden parachute includes a generous severance package, cash bonuses and stock options, the handshake goes further.
A golden handshake adds the retirement benefits to this termination package. The retirement benefits are those to be given if you are to retire when working in the same company.
Generally, retirement packages are very generous.
At the same time, golden parachutes come with many benefits. When these two are put together, the result is the golden handshake.
As a result, the golden handshake provides more benefits than the parachute alone.
Golden Parachute vs. Golden Handcuff
A golden handcuff works differently from the parachute.
While the golden parachute is intended to provide a soft landing for you when terminated, the golden handcuff is meant to stop you from leaving the company.
This is done by putting together great benefits and some costs. The benefits are for staying and the costs are for leaving within a certain period. This is especially the case when you could leave and join a competitor.
For example, if you leave, you would be required to return some company assets initially given to you. It can also take the form of a greatly-reduced severance pay.
ADVANTAGES OF GOLDEN PARACHUTE
Golden parachutes have been hailed for their benefits.
The benefits here are not from the perspective of the recipients, but the company and the staff remaining behind after the CEO leaves.
As such, some people have rooted for them.
Moreover, for the companies in acquisition-prone environments, this is seen as a good solution.
Some of the advantages are:
Ease in hiring and retaining top talent.
It is easier to hire employees in the low and middle levels as opposed to higher levels.
This may not make much sense if you consider that there are more candidates at lower levels compared to higher levels.
Still, hiring a C-suite employee is more daunting than lower-level employees. The reason is quite simple. These individuals look for job security more than anyone else.
They want to be sure that they have the authority to make decisions without being afraid of losing their jobs.
Since these are the people who are relied on to drive the company forward, you have to create a conducive environment for them. You have to provide attractive perks and these are never cheap.
Since mergers and acquisitions often lead to a change of guard at the top, CEOs often get replaced.
As job candidates, these CEOs always consider the company approaching them for a position. Or if applying, they will consider the termination package before making the application.
The company providing great benefits will attract the greatest minds. And those benefits prevent the CEOs from leaving for a similar position in a competing company.
Keeps top executives objective during merger and acquisition talks.
Talks about mergers and acquisition are not easy. Emotions flare up and resentment builds up. Friends can easily become enemies because people on both sides of the table have interests to protect.
But mergers don’t happen for the interests of the top managers. They often happen for the interest of the business.
The business may be dying and can only be resuscitated through an acquisition. Such a move could also be the initiative of shareholders.
Remember that the CEO needs job security like everyone else? And he doesn’t want to lose the big salary?
Many times, CEOs and other top managers try to thwart acquisition or merger plans. They can do this by making it difficult to reach an agreement.
Where a CEO is assured of a hefty send-off package, he is more likely to act in the best interests of the company. This is because his interests are already taken care of.
Discourage hostile take-overs.
Golden parachutes are a big expense to the company.
And when a company is being bought, the acquiring company is responsible for paying out the golden parachute. As such, this can present a challenge to the acquirer.
Considering that business are started with the intention of withstanding competition and being successful, it becomes wise to safeguard it against hostile moves.
Because these payoffs run into millions of dollars, they are at times put in place to discourage acquisitions.
To prevent a business take-over from a hostile competitor, many companies will include a golden parachute in the top manager’s contract.
Since this is an expense to be borne by the acquiring company, they will have to consider this as the cost of replacing the management.
Top managers also take a lot of responsibility in the running of the company.
This leads them to eventually developing a personal sense of ownership of the company.
If it grows, they are proud of it. If it fails, they feel the shame and embarrassment.
In such an environment, the management will not necessarily want an acquisition to happen.
When there is a golden parachute in place, buying out the company adds to the total cost and the move may prove too expensive.
Prevent employee retaliation after termination.
Another big reason for these hefty packages is to prevent retaliation by former high-ranking employees.
Retaliation can be dangerous for the company considering that the employee has the knowledge of how you run your operations.
When you fire a CEO, your business might get into serious trouble if he decides to retaliate. There are two major ways he may act against you depending on the circumstances of his departure.
1. Suing – this is a common route taken by disgruntled former employees. Their complaints may be valid or otherwise. But the process itself has many effects.
He may sue you for unlawful termination, unfair treatment or any other reason he decides to use. And since you are the perpetrator of the alleged crime, the suit may ask that you pay for the costs involved in the case.
When you are taken to court by a former manager, you can expect that this will cause a stir. It will be the topic of discussion among your employees.
Also, especially if you are a big company, you are bound to attract lots of negative media attention.
Of all the things that could happen, losing such a case is the worst. This will not only confirm all the allegations from the former staff, but will also force you to pay huge amounts of money.
In an effort to prevent a situation like this, companies use golden parachutes. They make the deal so good that an employee will not have a problem being fired. Though he may not like it, he will actually see no loss as the benefits given are good.
2. Disclosure – another problematic scenario is when the terminated staff decides to let your competitor in on your trade secrets. This can cause adverse effects on your business.
With the knowledge the former staff has, he can help your competitors bring you down quite easily. This is why employees are directed to sign an NDA (Non Disclosure Agreement).
Although it is in good faith, the agreement can be broken. And when someone does that, especially when he is no longer your employee, it can be tragic for your business.
Your competitor may know the terms you have with suppliers which allow you more cash flow. They may also get to know how much you pay your best employees.
From this information, they may poach your best talent and lure them with a better pay or benefits.
So much loss can be experienced as a result of disclosure. This is one reason for the inclusion of a golden parachute in the contract of the CEO.
DISADVANTAGES OF GOLDEN PARACHUTE
Good as they may be, golden parachutes are surrounded by controversies.
These controversies mainly revolve around the huge amounts of cash payments and other benefits provided for the terminated employees.
Perhaps worse than that, is the fact that these agreements are rarely known by the shareholders.
Essentially being the owners of the companies, shareholders are often the ones speaking out loudest against these packages. Here are some disadvantages.
CEOs are already highly-paid.
This is a fact in all companies. Although different companies pay their top managers differently, these employees are definitely the most highly-paid.
Consider the 25 most highly-paid CEOs as at March 2019. Click on the image for the full report.
As such, a generous payoff after termination is seen as unnecessary.
For the purposes of securing a comfortable life after termination, it is argued that their high pay can accommodate enough savings and investments.
This becomes more of an issue when the pay of other staff is compared to that of the managers.
There is always a big difference between the salaries of all staff. And so when the highest-paid is given a big send-off package, it simply doesn’t go well with low income earners.
Executives should naturally act in the company’s best interest.
This is the argument against the idea that a golden parachute enables the CEO to be objective during acquisition talks.
Opponents of golden parachutes claim that the CEO was running the company with its best interests at heart.
If the company is being bought by another, then he should not shift his loyalty from the company to himself.
Although this is a noble view of the CEO, its truthfulness is largely determined by ethics and integrity. Of course, these are traits which all CEOs should have.
But when one’s own interests are threatened, you can never be sure how they will respond.
At the same time, this argument shows the potential human frailty in everyone. It may thus seem that without external motivation, prioritizing other people’s interests is not easy.
Golden parachutes may not necessarily prevent a take-over.
As expensive as golden parachutes are, they are usually only a small fraction of the total cost of an acquisition.
The costs involved in acquisitions are far above the expense of the golden parachute in question.
This fact weakens the argument that these packages will prevent a hostile take-over. Instead, they are viewed as having very little impact in trying to prevent it.
Here’s a video of how a hostile take-over happens.
In many cases, golden parachutes constitute of three or more years’ annual pay of the executive plus other benefits.
These benefits generally include stock options and a generous severance pay. The acquisition cost on the other hand may include the value of all company assets.
Comparing these costs, you will find that the individual or company buying an existing business has enough money or motivation to pay the package.
So, though it was meant to deter a take-over, it ends up being unable to serve its purpose.
May possibly reduce the company’s profitability.
As an expense being paid out, golden parachutes affect the financial status of the company. Where cash bonuses are involved, lots of cash will be paid out.
Where large amounts of stocks are given, more money will be paid out when paying dividends.
Above all, the severance pay may be what digs deepest into the company’s cash reserves. Low amounts of cash affect a company’s ability to run its operations comfortably.
It may impact important operations, prevent it from taking advantage of opportunities and indirectly impact on profitability.
May lead to the CEO’s poor performance.
Golden parachutes may have a very negative effect on the performance of the CEO entitled to it.
Since there are huge amounts of cash and generous benefits involved, the executive may develop the wrong attitude towards work.
He may not see the need to work hard or put his best foot forward. He may become reluctant to make tough choices and give a lackluster performance since he has nothing to lose.
The real factors affecting the performance of the top managers may not be clearly known to the shareholders and other employees.
That however does not stop them from discussing how he is under-performing. All that many people care to look at is the overall growth trend of the company.
If the company is growing, employees and shareholders want to feel it. This is by getting higher dividends, share prices going up and staff salaries being increased.
If these things are not happening, then as far as others are concerned, there should be a change at the top.
May cause animosity and resentment among staff.
By all means, some send-off packages have been outrageously big. The cash and bonuses have been high, not to mention the other benefits included in the deals. Often, the revelation of these packages leads to an outcry by employees.
When it becomes known that this the treatment given to top managers while other employees complain of low earnings, resentment can easily build among employees.
This will be seen as a sign of favoritism and unfair treatment.
If not handled properly, animosity may be the outcome.
This creates a negative work environment and business growth may become more of a dream than a reality.
Golden parachutes have arguments both for and against them.
If you are in a position to determine whether to implement one for your CEO, keep in mind the pros and cons.
This will help you balance everything accordingly and hopefully keep everyone happy.
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