The Carrot-And-Stick Approach: The Employment Agreement
Joseph W. Bartlett, Special Counsel, McCarter & English LLP, Co-Founder of VCExperts
McCarter & English LLP
2002-08-02
In the early stages of a company's existence, opposing principles should be balanced in the planner's mind. First, since the unseasoned firm is so dependent on critical people, it is important to tie those employees–the key ones at least–to the company as tightly as possible. It must be kept in mind that the founder and some of the key employees carry the business around in their heads. If they are free to walk out, to set up a new and competing business on the other side of Sand Hill Road in Menlo Park or Route 128 in Lexington, the investors may find that their entire stake has been sacrificed. On the other hand, the savvy planner also realizes that many of those in the first wave will ultimately be fired or passed over. With rare exceptions, the skills required to go from birth to adolescence are not the same as those needed to carry the firm to and through adulthood. The scheme, from the company's point of view, must take into account the real possibility that the very employees who are so critical to early success will be redundant in the later phases. An employment contract is analogous to one of Donald Trump's prenuptial agreements: What does one pay in advance for a divorce?
The contract between the company and its key employees is a highly significant document in venture finance. It specifies salary and other benefits, of course, but the well-drafted version goes far beyond those topics. It deals with control of the company's future and protection of vital assets, including the people who possess the intellectual property, which is the backbone of many a start-up firm.
An employment contract reads as if Mr. Smith is being promised a long-term position with Start-up, Inc., for an annual salary plus, perhaps, equity in the firm, in consideration of Smith's promise to perform as, say, CEO for five years. Neither promise, however, is exactly what it seems. Realistically, Start-up's board of directors is saying to Smith, "If we want to fire you, we will pay you X dollars for your equity and Y dollars to buy out the remainder of your contract." Smith is saying to Start-up, "If I decide to quit, you can get some of your stock back for nothing and the rest for Z dollars, plus a restraint to keep me out of your business for, say, one year."
The contract, in other words, is like a prenuptial agreement. As long as the parties are happily married, no one reads the document; the principal issues have to do with the payoff numbers when divorce ensues–what are the partners' remedies in the case of breach? Professor Harold Shepherd at Stanford Law School used to divide his course offerings on the law of contracts into two distinct sections: one having to do with the formulation of the agreement and its administration, and the second, which he labeled "Remedies," having to do with the rights of the parties in the event of breach. Employment agreements, because they are not specifically enforceable in the sense of requiring the parties to remain married, become interesting when they fall into Shepherd's latter category: What to do in the case of breach.
Termination and Expiration
In discussions of the employment relationship, confusion often crops up, creating troublesome misunderstandings when the agreement is reduced to writing. If the employee demands a "three-year" contract, that means either: (1) he is promised a salary from, say, January 1, 2006, through December 31, 2008, meaning that the employee is contractually guaranteed a salary over an ever-decreasing amount of time; as of, say, October 2008, the salary protection has shrunk to a matter of months; or (2) alternatively, a "three-year" contract means that the employee is hired on January 1, 2006, and is entitled to what amounts to three years' severance pay whenever he is terminated other than for cause or by his voluntary act. The employer, in effect, has issued an "evergreen" promise to pay him three years' salary regardless of when termination occurs, the day after he is employed or ten years after. When considering the merits of each scenario, one has to go back to the point that the employment arrangement centers around the cost of buying out the employee's contract. With an evergreen provision, that cost is constant. Employment for a fixed term, on the other hand, makes it easier for the employee to be fired the longer he is with the company and thus fails to give the employee a fixed level of protection. Therefore, a multiyear employment contract usually refers to the evergreen arrangement; strictly speaking, the employee is terminable at will, subject to the severance arrangement. Assuming that the parties' minds have met on the term of the severance, the remaining issues concern "price"–what events give rise to the obligation of one or the other parties to pay a penalty, and in what amount? The contract may and may not also specify that the severance payments terminate if and to the extent the employee finds another job during the severance period.
Equity Recapture
Often the most potent penalty imposed on a footloose employee is the recapture of non-vested equity, either options or cheap stock. If the draftsman employed by the company has kept the main chance in view, he will recall that the object of an employment agreement is multifaceted: to stimulate the employee's current performance and to keep out of his head visions of sugar plums dangled by competing firms. If valuable equity can be recaptured at a penalty price when the employee quits, the term "golden handcuff" becomes apt. The vanishing employee may cause the investors to lose their entire investment, perhaps running into millions. The weapon used to avoid that unhappy result, is to string out the vesting of equity incentives as long as possible. It goes without saying that the employee's power to assign shares subject to forfeiture must be openly and notoriously restricted; otherwise, the possibility of forfeiture could be neutralized by a transfer to a bona fide purchaser whose lack of knowledge cuts off the forfeiture restraint. Further, it is customary to distinguish the level of recapture, depending on the occasion. If, as the earlier discussion assumes, the employee quits voluntarily–in the worst case, to join a competing firm–or is fired for cause, then the most severe recapture is called for. If the employee is fired for reasons other than cause, or dies, then either no provision is made or a modified quantum of non-vested stock is affected.