HR Due Diligence: What to Test, and Where Each Finding Lands

People Costs Belong in the Earnings Review

People are often the largest cost in a services or software business, so HR findings rarely stay inside HR. They move earnings, and earnings set the price.

The quality of earnings review is where that happens, and HR evidence feeds it directly:

• Obligations earned but not yet paid: bonuses for the period, commissions on booked revenue, accrued leave the company may have to pay out, and overtime the payroll has not caught up with.
• Owners and their relatives on payroll at pay that does not match the role, in either direction. Normalizing that pay changes earnings.
• Roles the plan needs but the company has not filled. An open senior hire is a future cost that current earnings do not carry.
• In a carve-out, people costs the parent carried centrally, such as payroll, benefits and HR services, which the standalone business will now have to buy.

Each of these moves the earnings figure the buyer is paying a multiple of, which is why the HR advisers and the accountants should work from the same payroll data rather than two copies of it. An adjustment the HR review finds and the earnings review misses still costs the buyer money. It just costs it after close.

Worker Classification Turns on Evidence, Not Labels

Contractors are cheaper to engage and simpler to part with, which is why classification is one of the first places a buyer finds exposure. A contract that says contractor does not settle the question. The IRS looks at the whole relationship and groups the evidence of control and independence into three categories:

• Behavioral: whether the company controls, or has the right to control, what the worker does and how the work is done.
• Financial: whether the company controls the business side of the work, such as how the worker is paid, whether expenses are reimbursed and who provides the tools.
• Type of relationship: written contracts, employee-type benefits, whether the relationship is expected to continue and whether the work is a key part of the business.

No single factor decides it, and the agency says so. For the buyer, the task is to assemble the evidence, not to make the call. Request the contractor agreements, a payment history for each individual contractor and a description of who assigns and reviews their work. Then flag the patterns that deserve counsel's attention: long tenure, a single client, a managerial title, company equipment, work that looks like the work employees do.

The classification decision, and any remedy, belong to employment counsel. Diligence contributes the evidence and the count: how many people, for how long, and what they would have cost as employees. The IRS notes that a business that treats an employee as a contractor with no reasonable basis may be held liable for the employment taxes for that worker, and state rules can apply tests of their own. When the buyer acquires the company itself, that exposure comes with it.

What Close Triggers in Employment Agreements and Pay Plans

Some obligations sit dormant in the documents until the deal itself sets them off. Find every one before signing, because after signing they are the buyer's.

Review each executive employment agreement, bonus plan, equity plan and severance policy for language that responds to a change of control:

• Acceleration: equity that vests at close (single trigger) or on a termination after close (double trigger).
• Transaction bonuses promised to the people who help sell the company.
• Severance that becomes payable, or more generous, if a role changes after a change of control.
• Retention promises made informally, in emails or offer letters, that no schedule lists.

These payments carry a tax question as well. US federal tax law allows no deduction for an excess parachute payment, and the definition starts from compensation that is contingent on a change in the ownership or effective control of the corporation. The rest of the test is technical, so every change-in-control clause goes to tax counsel. The job of diligence is to make sure none is missing from the list counsel receives.

The same documents feed the human capital work. A single-trigger acceleration clause on the person the business depends on is a key-person risk as well as a cost: close makes that person financially free in the same week the buyer needs them most.

Benefit Plans Carry Liabilities a Seller May Not Price

Benefit plans are where people obligations can outlast the people. A retirement plan with a funding shortfall, a self-insured health plan with claims incurred but not yet paid, or a plan run out of line with its own documents can each leave the buyer with costs nobody put in the forecast.

Ask for the plan documents, the summary plan descriptions, any actuarial valuations and the annual filings. In the United States, employee benefit plans file the Form 5500 series to meet their annual obligations under ERISA and the Internal Revenue Code, and the government describes those filings as a disclosure document for plan participants and beneficiaries. That gives the buyer a record of the plan that the seller did not prepare for the deal. Compare the filings with the data room. Differences in participant counts or plan assets, and filings that arrived late or not at all, are questions for the seller and for benefits counsel.

Benefits are also where structure changes the answer. Whether the buyer inherits a plan, replaces it or keeps it running for a transition period depends on how the transaction is structured and what the purchase agreement says. Settle it early, because the answer moves both the price and the integration plan.

Obligations That Follow the Workforce Depend on Structure and Timing

Two questions decide which employment obligations the buyer takes on: how the transaction is structured, and when things happen relative to closing.

Structure first. When the buyer acquires the company's shares, the company remains the employer, and its contracts, records and liabilities stay with it. When the buyer acquires assets instead, employees are usually offered new employment, and which obligations transfer becomes a question of law and of the purchase agreement. Countries differ too: some move employees to the buyer automatically in a business transfer and require the seller to pass employee information across before it happens.

Timing second. Some duties attach to whoever is the employer when an event occurs. The US federal rule on plant closing and mass layoff notices is an example. In a sale of part or all of a business, the seller is responsible for notice of any plant closing or mass layoff up to and including the effective time of the sale, and the buyer is responsible for any that takes place after. A buyer planning reductions after close owns that notice.

Records follow the same logic. A buyer that continues the seller's employment records, rather than starting new ones, inherits whatever gaps and errors they contain. Map each obligation against the structure and the closing date early, and have counsel confirm whether any change planned after close triggers a duty.

Claims, Complaints and Settlements Show How the Company Treats People

The dispute history is the closest thing HR due diligence has to a behavioral record. It shows how the company treated its people when things went wrong, and what that cost.

Ask for pending and threatened claims, settled claims and their terms, agency charges and audits, internal complaints and how they were resolved, and any collective agreements or organizing activity. Then read the pattern, not just the list:

• Repeated claims of the same type, such as overtime, discrimination or retaliation, point to a practice rather than an incident, and a practice tends to continue after close.
• Settlements with confidentiality terms clustered around one manager or one site are a leadership question as well as a legal one.
• Complaints resolved quickly and documented well suggest an HR function that works. Complaints that vanish without a record suggest the opposite.

Keep the two kinds of finding apart. The legal exposure, meaning what a pending claim might cost, goes to counsel and into the price or the purchase agreement. The pattern, meaning what the claims say about management, belongs to the deal team and informs the management team assessment and the culture review.

Where Each Finding Lands: Price, Protections or the Integration Plan

An HR finding that goes nowhere is wasted work. Each one should end in one of three places:

• The price. A quantifiable obligation, such as unpaid overtime, accrued bonuses or a benefit plan shortfall, adjusts the price or the earnings the price is built on.
• The protections. An exposure that cannot be quantified yet, such as a pending claim or an open classification question, goes into the purchase agreement as a specific indemnity, an escrow or holdback, or a closing condition. Counsel drafts it, and diligence supplies the evidence.
• The integration plan. Findings about how the company runs its people, such as inconsistent pay bands, missing policies or an HR function that will not scale, become first-year work in the post-merger integration checklist, each with an owner and a date.

Insurance does not remove the choice. Published legal commentary on representations and warranties insurance notes that a buyer cannot recover for liabilities it knew about when the policy was bound, and that some policies carve out underfunded benefit plan liabilities and liabilities related to employee misclassification and wage-and-hour compliance, whether known or unknown. A known HR finding therefore has to be priced or protected in the deal itself. The policy wording decides the rest, so the buyer asks its broker and counsel.

Record where each finding went. The integration team inherits the evidence along with the people, and the talent risk matrix is a practical place to carry the people findings into the first hundred days.