I regularly recommend the Waypoint NDA to clients who need a basic NDA, meaning one that is intended to allow them to begin discussing a potential transaction quickly and cheaply while taking reasonable steps to protect the interests of the parties.

Sometimes, a CEO will say “make this a unilateral NDA because they’re not giving us any info.”

This approach usually doesn’t create any benefits, let alone advantages. Sometimes it’s a net loss.

First: many counterparties will simply request as a matter of course that any NDA be mutual. Unless you have a contract of adhesion, where you’re willing to walk away from negotiations rather than agree to an NDA, or the situation is legitimately one where an NDA shouldn’t be mutual, you’re going to agree. So why waste time and money trying to gain a trivial advantage?

Second, if one party is trying to be protected, it will ask for all kinds of terms. If the other is only bound, it will push back on all the terms as a matter of course.

This means that the terms may not end up at the right place, which is an “efficient” allocation of risks (from a law & economics perspective). Any mismatch means something is wasting value.

Third, if you’re trying to get unrestricted access to the other side’s confidential information, then you’re already asking for trouble. See point 1.

The outcome in a world where the NDA is mutual is that point 2 never arises because both sides are now more aligned on terms: neither wants to extract a term so onerous that it wouldn’t want to have to observe it.

That in turn is why it saves everyone time and money by starting with a mutual NDA, such as the Waypoint NDA. It’s designed by real lawyers* so that our clients can trust that the terms make sense – on both sides – while protecting everyone.

From a board perspective, fighting over terms you’re going to agree to is seldom part of the strategic plan or how I expect the CEO to create shareholder value.

• I’m one of the lawyers contributing to the project, which is led by Kyle Mitchell.

Here’s a quick summary from both sides: Mergers & Acquisitions.

There are two stages in diligence: initial diligence, the purpose of which is to determine whether to make an offer and to set the price and terms for that offer; and full diligence.

A buyer has one major goal in doing full diligence on the seller. The purpose of full diligence is to confirm the assumptions, stated and unstated, that underlie the offer that was made. Thus, each assumption that is not confirmed yields one of three responses: either the price changes, the terms change, or the deal is killed. (Assumptions that are confirmed have no effect on the deal; if your assumption doesn’t affect one of those things, then it wasn’t really an assumption supporting your offer.)

From the seller’s side, diligence on the buyer has more possible reasons, all depending on the deal. A seller may want to confirm the buyer’s ability to finance the deal, its history of post-merger integration and operations, its willingness to support higher earn-outs, or its culture and workplace environment. At the same time, seller diligence of a buyer will often be relatively light in comparison. Where would that change? In a deal that looks more like a merger of equals, where the seller is taking stock as consideration, the seller board has to form an opinion about whether the buyer’s stock is worth what the seller thinks it is.

Why Do Diligence At All?

Recently, someone asked about a pending deal “Do we really need to do due diligence?” The buyer is eager to get the deal done – they want to be on the other side. That’s a great mindset: long transactions cost more money and bring more external risks. Time kills all deals.

Stages of Diligence

First Stage: Initial Diligence

There’s an initial stage, which is different for every company. It’s the set of questions and types of information that the prospective buyer wants and needs to make an initial offer on a term sheet or letter of intent. Each buyer needs different things for different kinds of deals. The important information can be financials, projections, technology, customers, or employees. Here’s a short-form diligence checklist that a typical buyer might use.

The LOI or Term Sheet

After the buyer gets that information and reviews it, it generally proposes a term sheet or letter of intent proposing the genral terms of the deal. That non-binding offer is always subject to further due diligence.

Second Stage: Full Diligence

This second stage of due dligence is what most people think of when they talk about due diligence. It’s a more formal process than the first stage that typically revolves around a due diligence checklist.

The buyer’s lawyers traditionally provide a comprehensive checklist. A typical DD checklist will contain many sections, covering all of the company’s operations and is intended to uncover every significant piece of information.

What’s the purpose of this whole second phase, especially when the buyer has already made the decision to buy the company and proposed a deal?

It’s the same thing as doing an inspection after you’ve put in an offer on a house: you want to be sure that what you’re buying is worth what you’ve offered.

The second stage of due diligence is designed to uncover facts that either confirm or change your assumptions about (1) what’s true and (2) what might happen. So, facts, and risks/opportunities.

What Do I Do with Due Diligence?

Each piece of information you uncover will lead to one of four possible outcomes:

• no change (e.g., you confirm from the tax returns the historical financials the target provided to you)
• a change in terms
  A very common fact pattern is when there is either outstanding litigation or an identifiable litigation risk, such as multistate sales tax or employee classification. The buyer will often change the terms to shift those known risks to the buyer, by increasing the amount of escrow, excluding those risks from the exclusive remedy of the escrow.
  A second common fact pattern is when the target’s projected EBITDA, on which a multiple was based, look less realistic after diligence. In those cases, a buyer may shift some of the purchase price into an earnout to bridge the gap between the buyer’s price and the seller’s. This change in terms avoids a fixed change in price by shifting the risk of performance to the target.
• a change in price (example: a target had lower collections of its invoices than its cash-basis financials indicated. With only an 80% collections rate, the projections for the business shifted, leading to a lower offer from the buyer. This is also a common result of “normalizing” a target’s EBITDA.)
• killing the deal
  Example: We had a client who’d offered to buy a small company. During due diligence, it became clear that the target didn’t have any meaningful contracts with its customers. It had relationships, but the buyer realized that it couldn’t rely on any contracted revenue for the next month, let alone any longer period. They killed the deal 2 days after learning this.

So, no, you don’t have to do due diligence, but you almost certainly should. As a director or officer, you’re quite likely violating your fiduciary duty of due care by doing none.

Risk Management

From a risk perspective, the kind of transaction you’re doing could lead to bigger losses than just the purchase price. There are some kinds of risks that are potentially larger than the value of the company: environmental; product liability; long-running wage/hour/classification problems. Other kinds of problems can quickly diminish the value of a target: IP issues; certain executive compensation problems; PR problems; internal ownership disputes; customer consent to assignment of contracts.)

Here’s the thing: you can’t know whether those things are actually there until you look. You can ask a seller and you can take their answer as the answer without looking at underlying documents, but even that’s a different risk than not asking the questions first.

Is There Another Path?

So is there an alternative position? Sort of, and I’ll give you a real example.

The alternative position is to still do first-stage diligence and make it clear to the seller that you’re going to rely on that information in the deal.

You send out your term sheet, and then you draft deal documents with a typical set of statements of fact (traditionally called representations and warranties), with the risk of falsehood of any of those items falling on the target. This is all standard. The difference is that you’re assuming these things: (1) that nothing you’d find would cause you not to do the deal at any price, and (2) that nothing you’d find would cause a change in terms or price that you can’t recover under the agreement.

Here’s a real-life scenario about an entire industry. When I was working in SIlicon Valley, it was common for venture funds to get “full” due diligence from companies in the course of a financing. I would read each of those documents and make sure there weren’t any dealbreakers in the pile. But eventually, that practice died out. Now, I can’t remember the last time that a VC requested diligence materials from an early stage company, or even from a later-stage company in a small deal. Investors have essentially determined that under their business model, doing a deal quickly with lower transaction costs is often a good tradeoff for the potential risks to them. If you take the position that ⅓ of all venture investments (and 60% of angel investments) go to $0, then it makes a bit more sense.

And similar trends are showing up in more traditional M&A deals. With asset purchases becoming far more common even for $50-100m deals, buyers are less concerned with unknown liabilities, as compared with 20 years ago when even small deals like that were typically mergers. (With a merger, the buyer takes on all the liabilities, known and unknown, of the target.) An acqui-hire is another good example of the kind of deal where limited diligence is necessary because most of the risks that process looks for just don’t apply to the post-deal world.

So that’s the counterargument. But that’s not an inconsistent position, really: it’s more like a special case where for an investor for the kind of deals it’s doing, it’s worthwhile trade-off. And that brings you back to the first stage of diligence. If you can learn what you need in that step, and don’t have to worry about other risks, then you’re in good shape. But that’s usually not the case.

Conclusion

We primarily do diligence to mitigate risks in advance of closing. No one wants to be on the receiving end of a nasty surprise, and most folks would rather avoid those deals than get the “wonderful” option of suing the other side.

There’s another pro-level reason to do full due diligence in an acquisition, but we’ll save that for another post on deal execution.

On both of these issues, my experience and education has made me overqualified as a director to manage these particular risks. So, if there’s internal debate or fuzziness from outside counsel, I will add thoughts based on my own experience to help frame the issues.

Finder’s Fees

The short answer is that it usually violates the securities laws to pay someone 5% of the money that is invested by someone they introduce. (Plus, that’s too much for a mere introduction in any case.) Registered broker-dealers, i.e., investment banks, are permitted to charge a percentage (which the SEC calls “transaction-based consideration”).

This rule applies to directors, officers, and employees. You can’t pay the new CEO a percentage of the money they bring in in the next funding round. You might give them a flat-dollar bonus based on the milestone of closing at least $X, but that’s as close as you should even think about getting to that line. Even that approach will break if you try to get cute: $50k for $5m round, $100k for a $10m round, and so on. The SEC will not be amused.

Yes, lots of people violate this law, and the SEC rarely imposes sanctions or brings cases unless there’s also fraud involved. But an unhappy investor is certainly capable of bringing a fraud claim. Do you want to put your personal assets at risk? Do you want to gamble with a losing case on a federal crime? I don’t, and I think most people shouldn’t either.

Accredited Investor Status

The SEC has created a number of regulations that provide safe harbors for certain non-public securities offerings to help channel folks toward good behavior that is intended to minimize the risks of fraud or of unknowing investment by the general public.

The accredited investor test is a cornerstone of this regulatory scheme. Many people think that the rule prohibits people who don’t meet the income or net worth tests from investing in private companies. That’s not true, and even people who should know better repeat it.

What the regulations do say to a company is that if you want to sell securities to accredited investors, there are generally no specific disclosure requirements: those folks are presumed to be able to look out for their own interests or to obtain learned advice from a third party to protect their interests.

If you want to sell to people who aren’t accredited investors, you have two options: Reg CF (for crowdfunding) which is relatively new, or make an awful lot of disclosures.

Companies could all raise money from the general public. But they uniformly reject the cost of those disclosures and don’t do it.

So, this background sets up the potential problem. If an investor is not sure if they’re an accredited investor, the company and its lawyers should generally avoid getting too close to that question. Provide resources and links to the SEC’s pages on the topic, but you generally want to stay out of the middle of it because a mistake just creates the potential for many headaches.

What I’ve seen companies do it harness a process that was added to Reg 506(c) to facilitate general solicitations, meaning letting a wide range of people know you’re trying to raise money. Before the revisions, goofing up this process led to a long quiet period, where the company would hopefully get everyone to forget its announcement, and then it would discuss financing only with specific persons with whom there was some kind of pre-existing relationship.

Now, 506(c) allows a company to make those kinds of broad announcements if it also takes “reasonable steps to verify” that each investor is in fact accredited. Essentially, this is more than what is required for a company not making the broad announcement.

So, a company that has a prospective investor who doesn’t know if they’re accredited can instead avoid getting entangled in that question or even trying to sort through the risks. Send the investor to one of the third-party verification services that sprang up after 506(c) was introduced. I haven’t used any of these, so here are just the first three I found doing a search:

1. https://www.earlyiq.com/accredited-investor-certificate ($69)
2. https://app.accredited.am/ (they pitch you deals)
3. https://www.verifyinvestor.com/ ($59-$69)

Have the investor go figure it out and give you proof. Cheap insurance, no messy personal data flowing into your systems, and you’ve avoided giving anyone bad (or unintentionally biased) advice.

These aren’t the only ways of handling these two issues, but as a board member, you have a duty to know about these risks and to help the company mitigate these risks or avoid them entirely.

Here are some basic ways of separating a business so that it’s more separate from an existing business:

• Putting it in a separate department or under separate teams with primarily shared services.
• Creating a separate division, with more dedicated personnel, with relatively fewer shared services.
• Creating a subsidiary of the original company.
• Creating a sister company under a new holding company.

There are obviously many variations of the first two, but if you consider them a spectrum, you can see that the two ends are very different.

Now, why might you separate a business?

• business reasons
• capital/financial reasons
• risk
• legal issues
• governance/management/leadership factors

Let’s cover each of these briefly.

1. Business reasons – you may want to separate a new business when it doesn’t mesh well with the existing one, such as no economies of scale, no shared customers, and relatively few shared resources. An example is a manufacturing company that wants to also provide advertising and marketing services. At some point, that second business is too different to function well inside the original company.
2. Capital and financial reasons – similarly, if the two businesses have different capital needs and rates of return, investors in the original business may not want to be in the new business, or vice versa. Consider a professional services business, like a consulting firm or software development. High margins, low capital requirements, and regular cash flow make those very different from a real estate development business.
3. Risk – this is a classic reason why real estate investments such as commercial buildings or apartment houses are often owned by separate LLCs. But it applies as well to businesses where the risk profile is very different – a web designer has very few risks (short of copyright infringement), but that business compared to the production of packaged snacks for people looks very different. You may want to separate those risks so that each business can be judged on its own merits and also so that risks from one business don’t damage the other.
4. Legal issues – some businesses have to be separate, such as because of ownership restrictions (such as licensed professions or S-corporations) or because the two businesses need different investors for some other reason. For closely held companies, a new partial owner for the second business almost always leads to creating a new legal entity to separate the businesses. It’s possible to allocate equity returns to specific businesses, but those lines don’t work if there’s a problem (see #3 – Risk).
5. Governance – if the businesses are different enough to consider separating them, it’s not a big leap to them having different capital requirements, different risks and returns, and different skills needed from the team. Sometimes, those differences can’t be well-managed inside a single structure, where a business creating cash may have that cash reinvested in a second business consuming cash instead of reinvesting in itself. Of course that can affect investors, but the sales and management team may feel that their prospects for future bonuses are being siphoned away as well. Sometimes, the second business just needs a different governance team entirely – board members with industry expertise, different strategic partners, management with domain experience.

Ultimately, the board’s job is to evaluate each new business opportunity as it develops with these frameworks in mind – not as a prescription, but as a mental model to watch the business as it develops and find a way for *both* businesses to be successful.

Uber “reported its first adjusted EBITDA profit of $8 million for the quarter.” Its actual loss? $2.4 billion – 300x bigger, and in the wrong direction. And they’re also giving adjusted EBITDA guidance….

In Q2 of 2021 their net income number was much better, $1.1B, but that was in part because of a big bump from the same Didi investment that hammered them in Q3 2021. (Another reminder to have a longer-term perspective unless you’re an HFT hedge fund.)

The real takeaway for investors, boards, and CEOs? Look at the cash flow statement to understand what’s really going on. Cash never lies unless someone’s actually lying. You can’t “adjust” cash or choose different accounting treatments to make more or less cash show up. And, as a reminder, the value of any business is the discounted sum of all its future cash flows. That’s why the board has to keep FCF in mind at all times: whether it’s cash today or cash tomorrow, you still need to bring it in the door.

What are some common adjustments? In the startup world, I see companies wanting to adjust their EBITDA for marketing expenses. The argument is that those expenses are discretionary, and so they could be returned to the shareholders as dividends or just increased FCF to the business. You know what I’ve never seen? A company adjust away their marketing expenses and then similarly adjust away the revenue they got from those marketing expenses.

That approach – we could market less, so consider us differently, isn’t entirely crazy except when it is. Looking backwards, it is crazy. Looking backwards and pretending growth won’t change going forwards is crazy too. Looking forwards and saying here are two alternate plans we could adopt – lots of marketing and a lot less marketing – isn’t crazy. Identifying the tradeoffs from reduced marketing expense and perhaps lower capital intensity is just good planning. Valuing the two alternatives is what management and the board have to do to make a decision of how to proceed.

But that’s not adjusting EBITDA: it’s tactical planning for how to execute the company’s strategy, and it pretty much is only here to highlight why pretending the past didn’t happen through adjusted EBITDA doesn’t work.

When I see public companies use adjusted EBITDA, it means that they see that the market is unhappy with the way they’re running the business and thus they say, “See? We could totally have done this, which is much better.” But they didn’t. They *chose* to run the company in the way they did.

They might as well say adjusted revenue – “we could have raised prices and made more money” – but they didn’t do that either.

We instinctively recoil against that because the law of supply and demand tells us that for most goods, there’s elasticity in price, and increased price typically means decreased volume. Whether that means more revenue or not depends on the specific shape of the demand curve over the relevant interval, but we all know this: there’s a tradeoff, and if you only show the good side of the tradeoff, we can all call BS.

The same is true with adjusted EBITDA, particularly when it’s something like marketing where the tradeoff is also obvious.

As an analogy, it’s not at all uncommon when calculating ROIC for a company for equity analysts to remove “excess cash” from the balance sheet because the company “could” dividend it out. But they didn’t. Pretending that a company like Apple isn’t sitting on $190 billion of cash and investments might be good, but we can all agree that pretending doesn’t make it true. Apple is using that capital. It’s not invested elsewhere in some other business.

So, what’s the real lesson? If you’re a private company, and you start using adjusted EBITDA, who’s that for? Who are you trying to convince that the past didn’t happen? When a startup spends a lot of money to acquire customers because they don’t have product-market fit, it’s one thing to *plan* for a better performance next year, and another entirely to pretend that you ran the race faster than you did. Could you imagine the Olympics with the world record holder losing to someone else? “My adjusted time in the marathon is 2:04, so I really won, when you think about it.”

So, if you’re a private company, I urge you to consider if using adjusted EBITDA is a way to avoid having the hard conversation of “why didn’t we accomplish what we planned?” And if you don’t have a plan, and don’t manage to plan, I can give you a multiple choice: three guesses and the first two don’t count.

But it turns out that performance-based incentives are tougher to create than you expect – at least the first time around. Equity-based incentives under stock option plans have been around for decades, and some particular structural features exist in part because they address some of the issues we’ll discuss here.

There are three main issues to consider when you’re developing performance-based incentives:

1. Compensation vs. retention
2. All or nothing goals vs partial performance.
3. Too many targets create the risk of conflicting goals at the margins.

Compensation vs. Retention

The first question is “what is your goal?” And the second is “Are you sure the employee sees it the same way?” If your employee sees an incentive as compensation, but you see it as retention, the terms aren’t going to do what you want them to. An employee will see that they’re not really getting the compensation – it may be deferred for several years – and simply not be able to afford to wait. They’ll take a better offer, and then you’ve lost out on the retention goal as well. The bottom line is that retention incentives seldom serve well as compensation.
 
 If you’re using an equity-based structure, you should think of compensation incentives more like cash, without additional strings attached. I’ve never heard a CEO say “and if you leave, I take back all your cash bonuses.” But I can’t count the number of times I’ve heard one say “and if they leave, they forfeit all the equity.” Not have to get bought out at FMV: forfeit.

All or nothing goals vs. partial performance

Some leaders want to focus a team member on an all or nothing goal: $X of sales, or a valuation in an exit of $Y. Picking an all or nothing target definitely focuses attention. But in many of those cases, an early question someone will raise will be “but what if we hit 90% of $X or $Y? Isn’t that worth more than 0?”

And they’re probably right. If you want to pitch this stretch goal, it works best when there is already a reasonable compensation structure in place. For example, telling a sales team that has a good comp structure that there’s an extra bonus for hitting a stretch goal may get the job done. But if they are underpaid in cash and commissions only kick in at a high level, you’re going to have to guard against the fallout from that mismatch: someone who is on target will stay, and anyone falling behind will likely just leave because they’re not confident about hitting the target and they’ll feel like they’re losing money every day of the journey.

Now, I’m not saying that every incentive has to start paying out at $0 and go up. It’s absolutely sensible to consider a floor with performance above that (e.g., using a break-even sales number as the floor). Your numbers still have to work and support the business.

Too many targets

Eagerness to fine-tune incentives is the shiny gold ring for many CEOs and boards. They recognize that performance is tied to a number of different factors and want to include them all in the mix.

There are two flavors of this: one is breaking up a big package into 4 or 5 smaller packages – 25% of the bonus is based on W, 25% on X, and so on. That’s not really a problem if you’ve been able to select targets that are independent. For example, hiring new team members increases expenses, so that target conflicts with a goal of lowering SG&A.

That same problem becomes impossible when an incentive system uses multiple performance metrics at the same time. I’ve seen a company set revenue, gross income, EBITDA, and net income goals for a senior team member, all of which had to be met to meet the incentive. That’s a lot of complication for any business that isn’t mature and stable enough to know the relationship of all the different variables in the equation.

If you’re selling Tide, you can probably predict what effect a potential modest improvement in marketing effectiveness would have on sales because there are decades of data. But for a startup, it’s a lot harder to say that all of those income statement lines are going to move in sync from one quarter to the next.

But trying, today, to predict the next three years of planning and results and lock it down in ink for a CEO is a tough job for a board. And you have to be prepared to re-open the conversation when either the strategic plan changes (your strategy probably shouldn’t likely change, but it happens) or your tactical plan changes. Tax laws could change and cause a company to shift from revenue growth (implying growth in valuation because of increased future cash flows) to net income growth (implying growth in valuation because of increased cash flows from operations). If your incentive plan is written for one or the other, someone’s going to want to have a discussion.

The time-based alternative

Many equity-based incentives use time-based vesting rather than performance-based vesting to avoid having guessed wrong. In a time-based system, the board can determine each period – month, quarter, year – what the CEO’s new targets are and evaluate the CEO’s performance against the last set of targets. That’s often more practical because plans are always changing based on where you are at that point in the future, not where you think today that you will be in a year. That’s why your GPS doesn’t tell you to drive for 4 hours and only then tell you that you’re not in Boston, you’re in Lake Placid. We adjust our short-term plans, aka budgets, on a regular basis.

Here’s why this works better in most cases: tradeoffs are inevitable, so if you create too rigid a system, a mismatch is almost certain. If you’re lucky, the team member comes back and says, “Hey, this incentive system isn’t working for me any more, so either we change it or I quit.” If you’re unlucky, they just quit. If you don’t change it, they still might quit.

If you use a time-based vesting system, you gain flexibility in setting the right targets at the right time and remove the pressure of picking the right future goals today. Now, that doesn’t mean that everything is automatically great. Complications will still happen, and so you’re trading that other conversation for this one with the CEO: “Hey, we’re not happy with the company’s performance this past year. Either we change your equity incentive or we’re going to fire you.”

The difference? With a time-based model and setting current targets each period, the board is leading the conversation; the board has the initiative to choose where and when to drive the discussion, how much variation is too much, and what to propose. All of that can be prepared in advance. The other way, the CEO is in charge of the discussion and the board is forced to react.

Yes, a board should be aware of the CEO’s incentives? They could be, but the person most likely to put those numbers in front of the board *is* the CEO (or maybe the CFO), so that’s again having the CEO in charge of the conversation.

Where do I fall between those two systems of targets and uncomfortable conversations? Yes, every situation might be unique and circumstances could vary, but I start with a clear bias for action. The principle of Offensive – seize, retain, and exploit the initiative – suggests to me that the board is better off choosing how and when to raise performance issues and being able to use time on its own schedule to prepare for the discussion and negotiations to follow.

Conclusion

So, consider being guided by the principle of Simplicity and aim for fewer complications in your performance-based systems.

Remember, incentives work. They’re better at affecting people’s performance than we are at creating them in the first place!

From the board perspective, this question is the one I always want to hear from the CEO and the entire senior leadership team. If the first response to adversity is “let’s lower the bar,” then you need to readjust the team’s mindset.  Seriously. And quickly.

A CEO I follow wanted their team to have a growth mindset but allowed this response twice in short succession when making a long-term plan. As for the current year, I expect they’re off plan. But I haven’t asked because the answer will be “X changed, and then Y changed, so we’re going to do Z.” And that will be the end of the analysis. No “how do we get back on plan?” No “how much does this change our projected valuation today, or in a year?”

It’s not easy to build a team, find revenue, operate efficiently, and create value for investors. But asking the questions is. If you’re at that point and ready for what comes next, you would do well to find your way to CerteVerus for help staying on the path.

I’ve seen companies go through this drill more than once. Two in particular stick out as having taken opposite approaches: one based on trust, goodwill, and a belief that the employees create value for the company, and one based on distrust and a view that payroll is just an expense to be minimized. You can choose your path, but one is more sustainable and resilient than the other. Choose wisely.

Inevitably, your company will have payroll screwed up – Friday morning, you’ll get emails and texts from your team asking about why their direct deposits have not shown up. These communications will mark the beginning of a very stressful day. But crisis management, big or small, all boils down to the same outline. Here’s how you can deal specifically with the most common payroll hiccups and get your team to the other side in as good a position as you can hope. Not following this path – particularly by not telling them the truth – risks having a major trust deficit to overcome once the dust settles.

Follow these steps:

0. Prevent– understand when your payroll has to be submitted and create a plan (read this post!) for what to do if there’s a payroll problem.

– A sizable chunk of payroll problems are self-caused: companies don’t submit timesheets before the company’s processing deadline.

– Sometimes you can arrange for a shorter deadline. The pro tip here is not to submit at the new deadline; it’s to submit on the regular deadline and use the slack to prevent problems when there’s a mixup.

1. Communicate – as soon as possible, send an email to all affected employees or contractors giving them facts – no conjecture, no false promises. You need goodwill from them to get you through this more easily; you don’t want to squander it by being less open with them than you would want them to be with you.

– be direct – short sentences without bureaucratese. Unless your lawyer or HR lead understand this, don’t let them near the keyboard.
– be clear – simple sentences, not long ones with qualifications and passive voice and “notwithstanding” and “provided, however”
– Describe the step in the process that didn’t work – this specificity shows, not tells, that you’ve investigated and are actively engaged in finding a solution.
– provide an estimated time for resolution, based on information from the payroll company. This timeline might be the time it takes you to resubmit and them to process, or it might be from their internal disaster recovery plan.
– provide the team comforting language describing the steps you’ve already taken and give assurances that you’re working to resolve the “systemic” issues that might be in play. “Solving things twice,” if it isn’t already part of your corporate culture, just got added. Fix the problem in front of you, and then fix the things that caused it to be a problem.

2. Communicate specifically – if people contact you about problems, you’re going to want to respond to each of them individually so they feel heard.

– This talk doesn’t necessarily have to be the CEO, but someone has to be speaking on behalf of the company to each of these folks. You get trust by being trustworthy.

3. Plan for two scenarios – end of month (if you’re a 2x/month payroll) and mid-month/other payrolls.
– end of month – the urgency here is that many of your employees will have scheduled automatic payments for rent and mortgages. Those amounts are relatively large compared to the payroll amount.

– mid-month – if you’re a 2x payroll company, many of your employees will have scheduled other payments to go out at that time – car payments, loan payments, and credit card payments.

– in either case, you will likely want to tell people that:
(1) you will reimburse late payment fees and overdraft fees that are reflected on statements.
(1A) you may wish to provide a letter from an appropriately senior official of the company to the employee and ask them to try to negotiate away the fees.

(2) you will want to have a mechanism for advancing money to people who will have a problem with not having cash (“I don’t have money for groceries”). That can be issuing an advance of some kind (you have to consider whether and how you would get money into their hands – you probably can’t use the payroll system or your AP system to get them money), and you can do that either automatically to everyone or to individuals who come to you with problems.

(3) in some cases, you may wish to give employees a “compensatory” payment or token of appreciation so that you don’t lose any goodwill from the mistake. This will be more important if the delay was caused by the Company’s mistake.

Keep in mind that about 40% of US households say they can NOT easily handle a short-term need for $400. That group certainly includes some of your employees. (That 40% is for all households; it is higher for certain racial groups and higher for households with a layoff in the past 12 months.)

Whether this payroll problem is your fault or your payroll company’s, you want to try to find solutions for your team to avoid major consequences.

4. Plan for potential state-level problems
– California, for example, imposes a penalty of $100 for the first non-willful payment delay, and for any subsequent or willful delay, a penalty of $250 AND 25% of the amount that was delayed. In that case, for example, you would want to work a lot harder to pay people via an alternate method to try to avoid penalties, especially if you’ve already had one problem. (See Step #0.)

5. Contact your payroll provider again – it would be ideal if they would compensate you for their error. Your contract may provide, however, that they do not have any liability for simple negligence (meaning you’ve agreed to release them from that potential liability and the price is effectively reduced because they don’t have to insure against those risks). If you saved money by not having coverage for problems, invest that money in preventing and solving problems.

– if they have a process for reimbursements, follow that.
– if you have an account representative, you can ask for a discount or one-time credit. You can at the very least ask for a refund of the payroll fees for that one payroll because the service wasn’t performed correctly.  
– if this is the result of a difficult or manual or confusing or multi-step payroll process, look for ways to simplify the steps. For some companies, that means using either the payroll company’s time and attendance software or software that has a supported API integration to avoid manual steps.

6. Prevention, part 2

If you have repeated external problems, you should look for a new provider. These problems (particularly if there are mandatory state penalties) can erode your employee goodwill. The way this kind of mishap turns out is definitely related to how good your employee relationships are – if they are antagonistic, you should expect a more difficult time with complaints, possible complaints to the state labor department, and union grievances if applicable. On the other hand, if your employees feel valued and trust management, they will take the explanation at face value and help you solve the problems by, for example, not asking for an advance they don’t need or by not complaining loudly if the short delay doesn’t really inconvenience them.

Payroll problems are almost inevitable with complicated systems and processes. Like any other risk, you likely can’t eliminate it, but you can manage it.

A bad meeting yields in unactionable advice in response to unanswerable questions.

Should we go slow or go fast?

Answer 1: look before you leap.

Answer 2: he who hesitates is lost.

That question is just an example: it could be any generic question to which any answer is probably correct in some way: Should we build or buy to expand? Should we raise as much money as we can or the bare minimum?

To help avoid ending up in this rest area alongside the highway, consider proposing specific plans with real details. Even well-meaning board members need some help to focus them on how to really make things different. If you show them a globe and say “we’re going to California,” they’ll say it’s a great idea. But if you show them your roadmap, route, stopping points, and itinerary, they can give you better advice like “Toulumne Meadows will be closed from Nevada this time of year” or “that’s a great hotel choice, and you should stay there two days instead of one.”

Specific questions demand – and encourage – specific answers.