The Critical Role of Cultural Covenants in Business Acquisitions
The Critical Role of Cultural Covenants in Business Acquisitions
A different kind of Covenant
At first our lawyers thought we were crazy. After a bit of explaining why we weren’t their typical PE client acquiring a founder-led business, they agreed this was novel, innovative, and even feasible. We hired an international M&A law firm that literally documents over a thousand business acquisitions per year. Yet no one on the team had ever drafted Cultural Covenants into an asset purchase agreement.
The “why” behind cultural covenants is to put your money where your mouth is. We weren’t the only prospective buyer telling sellers we are committed to preserving a great business culture, but we were actually the only ones that would draft contractual language around it.
Introduction to Cojourn
Cojourn is a values-driven holding company investing in enduring family-owned businesses. We partner with business owners to provide a superior exit process tailored to respect the legacy and ensure the continued success of the company post-sale. One distinction in our approach is including cultural covenants into our purchase agreements. These unique covenants enforce a contractual commitment to maintaining and nurturing the unique organizational culture that defines each business.
What is Organizational Culture?
Organizational culture can be likened to the foundation of a building. Just as a building needs a strong foundation, careful design, and maintenance to remain stable, a company’s culture requires thoughtful planning, nurturing, and attention. The visible parts of the building—walls, windows, and décor—represent the behaviors and practices we observe day-to-day. Yet, it's the solid foundation, hidden support beams, and underlying structural design that give the building its integrity and stability. Similarly, the unseen aspects of culture—core values, beliefs, and mindsets—provide the stability and strength that hold everything together. While the visible aspects of culture are important, the unseen structure is what truly defines and sustains the organization.
Why Does Culture Matter?
In most industries the products offered by competing businesses do not differ dramatically, but high-performing organizations distinguish themselves in how and why they develop and deliver their product. Organizational culture plays a critical role in this differentiation. According to McKinsey, organizations with top-quartile cultures, as measured by the McKinsey Organizational Health Index, post returns to shareholders that are 60% higher than median companies and 200% higher than those in the bottom quartile. *Professor James Heskett of Harvard Business School, in his book "Win from Within: Build Organizational Culture for Competitive Advantage," argues that an effective organizational culture provides businesses with a significant competitive edge. Higher employee and customer engagement and loyalty translate into greater growth and profits over time.**
What are Cultural Covenants?
The term "covenant" originates from the Latin "convenire," meaning "to come together." Historically covenants were agreements to establish the basis of relationships, including conditions, promises, and consequences.
In today’s business environment, covenants are contractual commitments to operate within certain guardrails. The most common covenants are financial covenants dictating leverage and profitability levels or organizational governance covenants dictating approvals for ownership changes, capital raising and other structural corporate changes.
Cultural covenants are different. They define essential practices, traditions, and values established by a business founder that an acquirer commits to uphold post-acquisition. They can be positive covenants (e.g. “our company will always…” or negative covenants (e.g. “our company will never…”). These culture defining commitments maintain the legacy and values established by founders, and ensure continuity of organizational culture. The historical and almost reverential significance of covenants underscores our dedication to stewarding the legacies of great founders and businesses.
Importantly, cultural covenants often include financial and other penalties if they are not upheld, underscoring their critical role in our acquisition process.
Specific Examples of Cultural Covenants
Cultural covenants aren’t just theory for us; they are put into practice. Here are some specific Cultural Covenant examples from our successful acquisition of OilStop. Note that each of these had meaningful financial penalties for Cojourn if we did not meet them during the defined period.
Maintain the Business Name and Mission Statement: The commitment to preserving the name "OilStop" and its mission statement underscores our dedication to maintaining the identity and purpose that the founder established, which is central to the company's reputation and customer trust.
Maintain Weekly Leadership Development Classes for All Employees: By continuing these classes, we ensure that the culture of continuous learning and leadership growth, which is crucial to the company’s success, remains intact and thrives.
Commit to Allowing Corporate Office to be Used for Voluntary Weekly Staff Bible Study Before Operating Hours: This covenant respects the founder’s values and provides employees with a space to engage in shared spiritual and community activities, reinforcing a sense of belonging and purpose.
Benefits
Cultural Covenants offer a series of powerful benefits for both buyer and seller in a business transition. Representative benefits are outlined below.
For the Seller
Preservation of Legacy: Sellers can ensure the unique identity, values, and traditions they’ve built over the years are preserved, providing peace of mind that their life's work will continue to thrive in a manner to make their family proud.
Employee Retention and Morale: The team is the most critical component of any successful business. Emphasizing and preserving culture will make employees feel secure and valued, reducing turnover and maintaining morale throughout the ownership transition.
Customer Loyalty: Customers often have strong attachments to the cultural aspects of a business. Preserving these elements will help retain customer loyalty and trust, which is essential for continued business performance.
Smooth Transition: Cultural covenants provide a foundation of trust, acting as a natural shock absorber to help both parties overcome the inevitable challenges of getting a deal done and facilitating a smooth transition.
Benefits for the Buyer
Employee Engagement and Productivity: Continuity in cultural practices helps in maintaining high levels of employee engagement and productivity, as staff continue to operate within a familiar and valued environment.
Operational Stability: By committing to cultural covenants, the buyer can ensure a more stable and predictable operating environment, reducing the risks associated with major cultural shifts that can accompany a transition.
Competitive Advantage: Businesses with strong, unique cultures often perform better and have a distinct competitive advantage. Preserving these cultural elements can enhance the company’s market differentiation.
Smoother Integration: Cultural continuity can lead to a smoother integration process, with fewer conflicts and misunderstandings, enabling quicker realization of synergies and business goals.
Summary
These benefits highlight the importance of cultural covenants in ensuring that both the seller's and buyer's interests are aligned. By facilitating a successful acquisition and preserving the unique aspects that made the business valuable and attractive to Cojourn in the first place, cultural covenants are not always included in our agreements but they can play a critical role in documenting our commitment to preserving the legacy of great business and offer business owners peace of mind knowing we are required to have our actions match our commitments. Cojourn is committed to honoring and extending the legacies of business owners through our long-term approach to acquiring and stewarding great companies toward enduring and impactful success.
**https://hbswk.hbs.edu/item/what-it-takes-to-build-an-organizational-culture-that-wins#:~:text=Heskett%2C%20the%20UPS%20Foundation%20Professor,into%20greater%20growth%20and%20profits
