Employment Due Diligence Checklist for Buyers
- Brandon Chicotsky
- Dec 31
- 13 min read
Updated: Jan 6
When buying a business, you’re not just acquiring assets - you’re also taking on its workforce, along with potential risks like unpaid wages, lawsuits, or compliance issues. Employment due diligence helps you identify these risks and protect your investment. Here's what you need to know upfront:
Employee Risks: Misclassifications, unpaid wages, or underfunded pensions can lead to costly liabilities.
Contracts & Agreements: Review employment and independent contractor agreements for hidden obligations like severance payouts or restrictive covenants.
Compensation & Benefits: Ensure payroll, bonuses, and benefits comply with laws to avoid penalties.
Retention: Identify key employees and plan retention strategies to maintain stability post-acquisition.
HR Policies & Safety: Outdated policies or safety violations can signal deeper management issues.
Workforce Structure and Personnel Details
Gathering a detailed employee roster and analyzing the organizational hierarchy can help pinpoint potential risks - like key employees at risk of leaving or improperly classified workers who might lead to legal complications.
Employee Lists and Organization Charts
Start by compiling a comprehensive employee roster. This should include names or IDs, job titles, departments, locations, hire dates, and tenure information [1][2]. Include compensation details such as base salaries, hourly wages, bonus plans, and any unvested equity or deferred compensation [1][5]. This data can highlight potential flight risks, particularly if critical employees are being paid below market standards.
Examine employment classifications carefully. Differentiate between full-time, part-time, and temporary workers, and ensure compliance with wage laws by identifying exempt and non-exempt statuses. Don’t overlook the contingent workforce, which includes independent contractors, consultants, agents, and "seconded" employees. Misclassification in this area could lead to liabilities for unpaid wages and taxes [5][2][1]. For international operations, track expatriates, verify visa statuses, and identify "stealth expatriates" - employees working abroad without proper documentation - which could lead to permanent establishment tax issues [2].
Organization charts are equally important. They map out reporting relationships and can expose "single points of failure" - individuals who hold critical knowledge or responsibilities without adequate documentation or a succession plan [1][6]. Cross-check these key personnel against the employee census to ensure their compensation is competitive. If they’re underpaid, retention risks could arise [1].
This level of detail provides the foundation for a deeper dive into turnover and retention trends.
Turnover and Retention History
Using the employee roster as a starting point, analyze turnover rates over the past three years, broken down by department and location [1]. Compare these figures to industry benchmarks. For instance, if a department has a 40% annual turnover rate compared to an industry average of 18%, it could signal underlying issues and hidden costs [1].
"High turnover in specific departments often indicates leadership issues or systemic problems that won't disappear after acquisition." - James Harwood, Soteria HR [1]
Review exit interview summaries and EEOC complaints to identify patterns of discrimination or management-related departures [1][5]. Examine performance improvement plans and disciplinary records to determine if turnover is "healthy" (removing underperformers) or "regrettable" (losing top talent) [5]. Retaining underperformers while losing top employees is a warning sign that could impact post-acquisition stability.
Finally, don’t overlook the contingent workforce. Long-term contractors and consultants might not appear in standard turnover metrics, but their departure can have an immediate and significant impact if they’re essential to operations [2].
Employment Contracts and Agreements
When reviewing employment contracts, it's crucial to uncover any potential liabilities. Missing or poorly drafted clauses - like unenforceable non-compete agreements or "golden parachute" provisions - can result in unexpected post-closing obligations.
Employment and Executive Agreements
Start by gathering all employment contracts, especially those involving executives. Pay close attention to change-in-control provisions, which may include accelerated vesting, bonuses, or severance payouts [5]. These "golden parachute" clauses can lead to significant financial commitments if overlooked.
Examine restrictive covenants like non-compete, non-solicitation, and non-disclosure agreements. For example, California generally prohibits non-compete clauses under Cal. Bus. & Prof. Code § 16600, except in cases tied to the sale of a business's goodwill [5]. On a national level, the FTC's proposed ban on non-competes remains unenforceable following a district court's ruling in August 2024. As a result, state laws continue to govern these agreements, requiring a careful, jurisdiction-specific review.
"A buyer-side employment lawyer can have a significant impact on a business transaction by spotting employment-related liabilities in the target company that might otherwise have gone unnoticed." - Anthony J. Oncidi, Proskauer Rose LLP [5]
In asset purchases, check for anti-assignment clauses that may restrict the transfer of contracts without employee consent [5]. If these clauses are present, you might need to negotiate new agreements or offer additional incentives, like signing bonuses, to ensure restrictive covenants remain enforceable. For unionized workforces, review collective bargaining agreements to identify successor clauses that could bind you to existing terms [3].
Take note of any severance obligations outlined in contracts, as these must be honored regardless of the deal structure [5].
Next, shift your focus to the classification and agreements of non-employee workers.
Independent Contractor Agreements
After reviewing contracts for direct employees, turn your attention to agreements with independent contractors. Carefully assess these agreements to ensure proper classification under IRS and Labor Department guidelines [5]. Misclassification can lead to costly liabilities, including unpaid overtime, inaccurate wage statements, and unpaid taxes [5].
"If employees are misclassified as independent contractors, or nonexempt employees are misclassified as exempt, liability can accumulate quickly in the form of meal and rest break violations, failure to pay overtime, failure to maintain and provide accurate wage statements, failure to provide final wages upon separation of employment, and other wage and hour claims." - Anthony J. Oncidi, Elaine H. Simson, and Cole D. Lewis, Proskauer Rose LLP [5]
Pay special attention to any recent reclassifications from contractor to employee, as these could indicate prior non-compliance and potential back-pay liabilities [5]. Between October 2021 and September 2022, the National Labor Relations Board reported a 53% increase in union election petitions [3], underscoring heightened scrutiny of worker classification and labor practices.
Evaluate the target's classification methods against the legal tests required in each jurisdiction where they operate. For instance, California's "ABC test" imposes stricter standards compared to federal guidelines [5]. Additionally, review any joint employment arrangements with staffing agencies or leasing companies. If the target exerts significant control over these workers, you could inherit liabilities related to taxes, workers' compensation, and unemployment insurance [5].
Compensation, Benefits, and Wage Compliance
When evaluating an acquisition, it’s essential to ensure compensation practices meet all legal standards. This step is crucial to prevent a seemingly lucrative deal from becoming a financial burden. Workforce-related mistakes, including errors in compensation, are a common reason nearly half of M&A transactions fall short of expectations [10]. Before finalizing a deal, confirm that payroll practices comply with federal, state, and local wage laws, and ensure benefits programs are legally compliant.
Payroll Records and Wage Laws
Start by reviewing three years of payroll records, overtime logs, and tax filings to verify compliance with the Fair Labor Standards Act (FLSA) and applicable state wage laws [7][9]. Misclassifying employees as “exempt” when they don’t meet legal criteria can lead to costly class-action lawsuits, with liabilities sometimes reaching millions [4]. It’s also critical to ensure that overtime pay is calculated correctly, factoring in elements like travel, meal, and prep times.
"A potential hidden liability in an asset acquisition is the seller's past wage and hour violations under the federal Fair Labor Standards Act (FLSA)." - Will Bishop, Jason Pill, and Austin Laurienzo, Attorneys, Phelps [4]
Successor liability is another important consideration. Under federal common law, wage and hour liabilities may transfer to the buyer, preventing companies from sidestepping FLSA obligations by selling assets and dissolving [3][4]. It’s wise to confirm with federal and state agencies that all Social Security, Medicare, and unemployment tax payments are current [9]. Additionally, review policies on sick leave, paid holidays, vacation time, and bonuses to ensure they meet statutory requirements [8][9]. To safeguard against unexpected employment-related liabilities, consider setting aside a portion of the purchase price in escrow for a specified period [9].
Once payroll compliance is addressed, turn your attention to reviewing employee benefits programs for potential risks.
Benefits and Retirement Programs
Thoroughly examine health insurance, retirement plans, bonuses, and stock options to uncover any funding issues or compliance gaps. Request key documents like Summary Plan Descriptions (SPDs), Form 5500s, and actuarial reports for defined benefit pension plans to assess funding adequacy [1][11]. Reviewing claims history and participation rates for health plans can also help project future costs [1]. Ensure compliance with ERISA (reporting, disclosure, fiduciary responsibilities), COBRA (continuation coverage), and HIPAA (privacy and security) [11].
Pay close attention to change-of-control clauses in equity compensation and bonus plans. Deferred compensation must align with Section 409A, while Sections 280G and 4999 regulate "golden parachute" payments that may be triggered by an acquisition [11]. For multiemployer pension plans, evaluate potential withdrawal liability, which can represent a significant hidden expense in M&A transactions [11]. It’s also important to estimate the cost of merging the target’s benefits programs with your own, especially if the acquired company’s offerings are more generous [1]. Overlooking these liabilities can erode deal value, and with over 70% of acquisitions failing to meet their intended goals [10], addressing these risks is critical to preserving value post-closing.
HR Policies, Workplace Culture, and Safety Records
When evaluating a potential acquisition, it’s not just about the numbers. A company’s HR policies, workplace culture, and safety records can reveal hidden risks that might not be immediately obvious. Issues like outdated policies, inconsistent enforcement, or recurring safety violations can point to deeper management problems that may persist after the deal closes. Taking a closer look at HR documentation and safety records can help identify these risks before they turn into costly liabilities.
Employee Handbooks and HR Policies
Start by requesting the company’s current employee handbook along with policies related to performance management, disciplinary actions, and paid time off (PTO). These should align with key labor laws like the FLSA, ADA, and FMLA [5]. If the policies are outdated or inconsistently applied, you could be exposed to successor liability claims under Title VII, the ADA, and the Age Discrimination in Employment Act (ADEA) [5].
Another critical step is to audit Form I-9 and E-Verify records to confirm that all employees are legally authorized to work [12]. If the company uses staffing agencies or contractors, dig deeper to see if “joint employment” applies, as this could increase liabilities, including taxes and union-related obligations [5]. Also, ensure the handbook includes clear job descriptions and consistent enforcement of policies to minimize risks.
Be on the lookout for warning signs like high turnover in certain departments or the absence of Employment Practices Liability Insurance (EPLI). Shockingly, only about 3% of small businesses carry this insurance, leaving them vulnerable to employment-related claims [12]. Quantifying these HR risks in monetary terms can give you leverage to negotiate the purchase price [1].
Once you’ve reviewed HR policies, it’s time to shift your focus to safety practices and compliance.
Safety Compliance and Legal Issues
A solid HR foundation is essential for maintaining a safe workplace, making safety compliance a critical area to review. Request OSHA reports, workers’ compensation claims from the past three years, and any pending safety-related litigation [13]. Dive into summaries of recent OSHA audits, EEOC complaints, and demand letters [1][5]. Patterns of repeated injuries or violations could suggest systemic management problems rather than isolated events [1].
Make sure the company has adequate insurance coverage, including workers’ compensation, general liability, and product liability policies [13]. Check for any unresolved judgments or settlements that could become your responsibility after the acquisition [13]. It’s also a good idea to document all your findings thoroughly. In some jurisdictions, a comprehensive due diligence process can protect you from being held liable for unknown wrongdoings by the predecessor [5].
Key Employee Retention and Financial Liabilities
After addressing safety compliance and legal matters, the next priority in any acquisition is ensuring the retention of key employees and identifying potential financial liabilities. Losing critical talent or overlooking hidden costs could jeopardize the success of the deal and strain your financial resources.
Retention Plans for Key Employees
Start by identifying key employees. These might include executives, officers, directors, managers, specialists, long-tenured staff, or individuals earning more than $300,000 annually [14][16]. These employees often hold vital institutional knowledge that isn’t documented anywhere else [1].
"For the M&A to be successful, it's important that key employees be retained." - IRIS FMP [14]
Past mergers and acquisitions (M&As) have shown that retaining key talent is crucial to achieving a successful outcome [15].
To prepare, request a detailed compensation schedule for all key employees, covering at least the last three years [16]. This should include salary, hourly rates, and non-cash benefits. Compare these figures to current market rates. Employees earning below market value may be more likely to leave once the acquisition is announced [1]. Additionally, review unvested equity schedules, deferred bonuses, and other retention agreements already in place [1]. Pay close attention to "change of control" clauses in executive contracts, as these may trigger large payouts or give executives the right to resign under certain conditions [1].
Plan for retention bonuses to secure critical staff for 12 to 24 months after the acquisition [1]. Confirm the enforceability of existing non-compete, non-solicitation, and non-disclosure agreements. If these agreements are weak or missing, be prepared to implement new ones, which may require additional costs [5].
Once retention strategies are in place, calculate the associated financial obligations to guide negotiations.
Employee-Related Financial Liabilities
Understanding and quantifying employee-related financial liabilities is equally important. Many executive agreements include provisions for accelerated payments, such as guaranteed bonuses or immediate equity vesting, triggered by an acquisition [1]. Review severance packages, salary continuation agreements, and "golden parachute" clauses to determine the potential costs [14][16].
Account for accrued bonuses, commissions, and unused vacation or sick leave. Be aware that state laws, like those in California requiring payment of vested vacation upon termination [5], may increase these liabilities [14][15]. Additionally, under federal common law, you could be held accountable for the seller's past violations of the Fair Labor Standards Act (FLSA), such as unpaid overtime or employee misclassification, even if the asset purchase agreement states otherwise [3].
Ensure compliance with ERISA regulations and evaluate any underfunded benefit plans to avoid unexpected penalties [14][1]. If consolidation of operations is part of the acquisition, calculate severance obligations for redundant positions and verify compliance with the WARN Act, which mandates 60 days' notice for mass layoffs [3].
"When you quantify HR risks with specific dollar amounts, you gain real negotiating power to adjust the purchase price." - James Harwood, Soteria HR [1]
Assign monetary values to all identified HR risks. For instance, underfunded pensions might represent a $2 million liability. Use these figures to negotiate adjustments to the purchase price [1]. For unresolved employment litigation or potential penalties for misclassification, consider negotiating an escrow account - held for a set period, such as 18 months - to cover any potential losses [1].
Conclusion
Employment due diligence isn't just a box to check - it's a critical safeguard that protects your investment from hidden risks that could turn a promising deal into a financial headache. In fact, many M&A failures stem from overlooked issues related to human capital [1]. This checklist serves as your guide to identifying and addressing those risks before the ink dries on the contract.
"The most expensive M&A mistakes are the ones you discover after signing." - James Harwood, Soteria HR [1]
By quantifying risks - like underfunded pensions or penalties tied to worker misclassification - you gain the power to negotiate adjustments in the purchase price or set up escrow holdbacks to cover potential liabilities.
This checklist also highlights the value of expert support, such as the services offered by God Bless Retirement. Their network of professionals - including CPAs, financial planners, and M&A specialists - can help uncover hidden liabilities, ensure compliance with regulations, and craft integration plans for the crucial first 100 days after the deal closes. Combined with the risk analysis detailed earlier, these steps help safeguard your investment, ensuring that you avoid inheriting compliance issues and retain the talent that drives the business's value.
Addressing employment risks upfront shapes the future of your acquisition. A thorough approach today can save you from financial setbacks and operational challenges down the road.
FAQs
What employee-related risks should buyers look out for during due diligence?
When assessing a potential acquisition, it’s essential to dig into employee-related risks that could affect the deal. Here are some critical areas to examine:
Worker classification: Misclassifying employees as independent contractors can lead to legal and financial troubles.
Wage and hour compliance: Look for issues like unpaid overtime or failure to meet minimum wage requirements.
Outdated or non-compliant documents: This includes employee handbooks, non-compete agreements, and severance terms that may not align with current laws.
Unpaid benefits or retirement liabilities: Mismanaged 401(k) plans, health benefits, or other obligations can become a financial burden.
Employment litigation: Pending or past lawsuits could signal unresolved legal risks.
Workplace safety concerns: Review injury records and check for OSHA violations that could pose regulatory challenges.
Union or collective bargaining agreements: These commitments could bring additional obligations for the buyer.
Addressing these issues early can save time, money, and headaches down the road. For help navigating these complexities, experts like those at God Bless Retirement can provide the detailed guidance and discretion needed for a successful acquisition.
What are the risks of misclassifying workers during a business acquisition?
Misclassifying workers can create serious financial and legal headaches for businesses. These problems can include back pay, unpaid taxes, penalties, attorney fees, and other liabilities that might stretch back as far as six years. In the context of a transaction, these risks can disrupt the process by triggering price adjustments, demanding extra indemnities, or even jeopardizing the entire deal.
To steer clear of these pitfalls, conducting a detailed review of worker classifications during due diligence is crucial. This step helps ensure compliance with employment laws and reduces the chances of facing unexpected liabilities.
How can buyers retain key employees after acquiring a business?
Retaining top employees is a key factor in the success of any business acquisition. To keep valuable team members motivated and engaged, buyers need to prioritize strategies that address compensation, benefits, and workplace culture.
Some proven methods include offering retention bonuses or stay agreements linked to a set post-acquisition period. Aligning compensation and benefits with the buyer’s framework - while preserving existing perks like 401(k) plans - can also make the transition smoother. Additionally, providing equity or performance-based incentives gives employees a personal stake in the company’s future success. Open and transparent communication about the acquisition process, as well as any potential role changes, is equally important for building trust and calming uncertainties.
For acquisitions under $25 million EBITA, God Bless Retirement connects buyers with seasoned HR and legal experts. These professionals craft customized retention plans to help keep essential employees on board, ensuring a seamless transition and setting the stage for long-term growth.
