In this article I would like to share some of the basic insights on the use of employment agreements – a tough challenge for many business owners. “Don’t need them! Don’t want them!” That’s how many owners respond to the concept of using written employment agreements for key employees. We’ll also discuss the top myths about Employment Agreements.
While the use of such agreements in larger organization is forever expanding down to deeper levels to hedge against the risks of expensive litigation and the loss or dilution of valuable proprietary rights, many smaller businesses still resist the need to get things in writing upfront with those who can do the most damage. The owners cling to the old notion that a piece of paper can’t make a bad employee good or a good one better.
So why bother? Usually, the reluctance to come of age on this one is a result of inertia and ignorance. A program of using smart agreements with key employees takes time upfront. Since many closely held businesses do not have a separate human rights person, much less a department, the burden of the effort falls on the chief executive officer or some other high-ranking officer who already has a more than full plate. Add to this a few common myths that question the whole value of the effort and it’s easy to let this priority drop to the bottom of the stock.
This post discusses three dimensions of the challenge. The first discusses and hopefully dispels certain of the common myths that often get in the way. It then shares some insights on the all-important issue of structuring smart financial incentives and such agreements. It closes by listing and briefly commenting on the key provisions that should be included in this type of agreement.
We start by looking at four of the common myths.
The myth is that the document produces more for the employees and less for the company. Why else would only a privileged few in the company have their own agreement? The real truth is that nearly all of the key provisions in an employment agreement primarily benefit the company in a big way. Such provisions include termination rights, confidentiality covenants, post-employment competition restrictions, intellectual property protections, work effort requirements, dispute resolution procedures, choice of law designations and more.
Even the compensation provisions benefit the company by spelling out the limits and defining expectations. Theoretically, a company probably would be better off if it could have a written deal with every employee, but practical problems of implementation would make the effort as silly as it sounds. So, smart owners rely on a carefully crafted employee handbook for the masses and use individual written agreements with those who can do the most good and cause the most harm.
The myth is that it’s counterproductive to get tangled up in legal minutiae during the courting phase with a key employee. The focus should be on positive business challenges and synergies, not potential problems that may never surface between the company and its newest recruit. The myth ignores a basic truth. Nearly all prospective employees long for the details of the whole deal showing that the key issues have been fairly thought through and incorporated in a document tailored for the new executive will not be viewed as a negative or an unjustified preoccupation with the dark side of business relationships. If done right, it will confirm that the company has its act together, values relationships based on detailed mutual understandings, and regards the potential executive as a valuable part of the management team. It can actually be an “upper” that removes uncertainties and facilitates a more complete understanding of the objectives and priorities of both parties, and if an insurmountable conflict surfaces during the process, all will benefit from its early detection.
The myth is that the details of the employment relationship with a key executive are easier to hash out after the executive has been onboard for a while. Everyone knows more, expectations are clearer. It’s wrong. The problem is that the job just won’t get done. Once the employee is in the saddle, what interest will the executive have in dealing with post-employment noncompetition restrictions, broad employer termination rights, dispute resolution procedures, and those types of things. In most situations, the company will be left with two lousy options to push the agenda along. It can get tough and demand its agreement which may undermine morale, mutual respect, and all the other intangibles that strengthen individual business relationships. Or it can offer something more which can get expensive. Far and away, the best time to work out the details and document the deal is just before the starting gun when both parties are anxious to find common ground and move forward.
The myth is that the process must take a long time and be lawyer-driven resulting in a document that must be long and full of unintelligible legal verbiage. Neither is required. The document for the employee can be based on a form that has been carefully prepared to cover the bases while keeping the language simple and short. Sometimes it is presented in the form of a letter that has a signature line for the employee’s consent at the end. Because the language in the form have been prepared and approved in advance, a company officer can quickly create the document with little or no lawyer input, plus the officer can be trained to explain the basis and rationale for the key provisions of the document.
Some employees will review the document, ask a few questions, and then sign. Others will obtain input from independent legal counsel seeking comfort while hoping that there’s nothing seriously objectionable to the document. Usually, the worst case scenario is that the employee’s lawyer requests a few harmless changes or clarifications that the company feels compelled to have approved by its legal counsel. Everything is wrapped up in a few days.
Now, there are rare extreme situations where the employee’s counsel demands major substantive changes that put the whole relationship in jeopardy. When this happens, the lawyers begin working for common ground while the company assesses its appetite for making special concessions to secure the particular executive. This unique scenario requires some time and expense, but the effort and the amount of time involved is a tiny fraction of what would be required if a full blown dispute broke out down the road. When serious differences are flushed out during the courting phase, the company should take comfort in the fact that the process is working.
Let’s shift now by focusing on one important element of the agreement process that often warrants careful analysis and that is shortchanged in far too many situations. It’s the money question, the compensation that is going to be paid to the executive. There are a number of factors that come into play on this all-important consideration. A threshold consideration is whether the details of the compensation package are going to be spelled out in the agreement.
Now, many companies try to dock this one, claiming that the real purpose of the agreement is to deal with non-compensation issues and that the money questions will be decided and adjusted over time as the relationships of the parties evolves. The company adores the flexibility and the lack of written commitment. Many executives demand more in right. Sometimes an effort is made to placate this demand by specifying the starting salary and adding some general feel-good language that promises reviews and undefined additional benefits down the road. But more often than not, an executive in high demand will demand and get details relating to salary increases, perks, bonuses, and other incentives all laid out in the agreement. When this is the game plan, certain factors usually need to be considered.
Many executives rank retirement planning as their number one financial concern. They want to know that they’re going to have enough at the right time; that they’re not going to outlive their financial resources. They want to know that they will be able to slow down and enjoy life free of financial worries even though the economy around them cycles from boom to bust. In many situations, the solution to this one is a supplemental executive plan provided by the company and tailored to the specific needs of the executive. The company’s regular qualified retirement plan is too watered down to do the job. An old-fashioned savings program is just too tough and social security, even if it’s available, is hopelessly inadequate.
For decades, companies have recognized the value of individually tailored retirement arrangement just for the key people. These arrangements are routinely used to recruit and retain valuable executive talent. The substantial benefits that accrue under the plan over time creates a powerful incentive for the executive to tow the line and to not even consider flirting with the competition.
Many highly motivated executives want to own a part of the business. They want to work with the business owners, not just for the business owners. Often the executive really doesn’t understand or appreciate what an equity interest in the business really represents. All the executive knows is that he or she wants to feel like an owner and be treated like an owner. It calls into play the potential of restricted stock and bonus stock grants, the possible use of qualified or non-qualified stock options or the value of phantom stock programs.
Many companies view this challenge as a necessary evil and approach the task with suspicion, fear, and a natural tendency to drag out and procrastinate the process. The company recognizes the value of the key executive and wants to preserve loyalty and dedication. What the company does not want to do is create a structure fraught with legal and tax complexities that unduly inflate the executive’s expectations, diver the executive’s commitment or worse yet, funds the executive’s departure. Many benevolent employers have adopted generous programs to share a piece of the rock only to find that the programs have spoiled a good executive crew by overinflating expectations and promoting misunderstandings and confusion.
And then there is the basic question of whether the executive is going to be given a specific bonus incentive to perform. Far too often the compensation issue is settled a salary and some vague bonus discussions that create expectations of more money but do nothing to perpetuate individual performance objectives. The different between real success and baseline mediocrity in many businesses is to drive the key executives who are charged with making it happen. This drive factor is tied directly to the executive’s focus on specific targets of success and how bad the executive wants to be better than good.
A smart bonus incentive can keep this driving factor hot for the executive. Here are a few key factors to consider:
The executive must be able to understand all specifics of the bonus incentive. It can’t be too complicated or tied to factors that are foreign to the executive. For example, to base the bonus on the growth of the EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) may do nothing if the executive, like many, cannot comprehend, let alone have any direct impact on broad range of elements that may impact the company’s EBITDA. The incentive must be objectively measurable. It should not be based totally on someone’ s discretion or will, although some subjectivity may be factored into the process. For example, the incentive for an accounts receivable manager may be a percentage of salary based on the percentage of accounts collected within 90 days. For example, a 7% bonus for an 85% collection rate, a 10% bonus for a 90% collection rate, and so forth.
The plan may also give the company CEO the discretion to increase any earned bonus by up to an additional 15% if the employee turnover rate in the accounts receivable department in a given year is less than 75% of the company’s average turnover rate. Such a bonus plan would be measurable and keep the manager focused on two critical success elements – collection percentages and employee turnover.
Also, the incentive must be large enough to matter. If the amount at stake is insignificant, the employee may pay lip service the objectives without ever believing that there are serious concerns that warrant additional effort and commitment. For example, an incentive for a customer service manager that promises a 2% of paid bonus if the number of customer complaints in a year falls below last year’s number may do nothing more than create something for the manager to watch and hope for. It may not trigger what is really required. An analysis of what is needed to reduce complaints followed by an effective implementation effort.
Also, the factors that impact the calculation of the bonus should be within the control of the executive. For sales personnel, it may be the volume of new customers. For an account manager, it may be growth in an existing relationship and the improvement in the ratio of direct service costs to revenues generated. For a production manager, it may be the average employee cost for each unit produced. For a distribution manager, it may be warehouse personnel compensation as a percentage of volume shipped and a reduction in waste, accidents, and absenteeism. For an accounting manager, it may be the percentage of targeted deadlines hit and the ratio of the accounting compensation to the volume of transactions processed. The key is to identify specific success factors that will result in the company becoming stronger as the executive makes more. It’s the classic win-win situation.
There must also be visible time monitors, specific techniques and procedures that enable the company and the executive to track and monitor progress on the bonus on regular basis at least once a month. Don’t have a program that is based on a surprise year-end calculation. One of the primary values of a targeted program is that it will create powerful incentives to see what is working and to adapt and push harder when needed. This need for being able to regularly monitor the bonus may require some special periodic accounting reports or some custom adjustments to the company’s computer and information system. But the benefits usually easily justify any added upfront expense or effort.
The advantage many small businesses have over the larger institutional competitors is the ability to adapt to change faster and to be more efficient and effective with all the details. It’s the old cruise ship versus speedboat comparison, and it’s a fair analogy in many situations. The key to really leveraging this advantage is a motivated, engaged, objective-focused executive team workforce. Smart money incentives will help build such a team because money is always a powerful motivator. The business owner who for reasons of neglect, ignorance, or laziness ignores the opportunity may soon end up with a speedboat that moves no faster than a cruise ship and that is bounced out of control daily by the wake of those who are doing it right.
Let’s wrap-up by recapping certain key non-compensation provisions that should be included in an employment agreement.
The first is the length of the agreement. The length of the agreement, its term is always a big deal. When it comes to the term of such an agreement, usually the agreement is structured as either an at-will agreement, a drop dead agreement, or an evergreen agreement.
An at-will agreement allows either party to terminate the agreement at any time for any purpose. t provides flexibility and the opportunity for a quick exit with no showing of cost. A drop dead provision means the agreement will end up on a given day unless the parties agree otherwise to an extension. Sometimes an agreement is structured to have an at-will deal for any employment period after the drop dead day. An evergreen provision, very popular in many agreements, provides that the agreement will run for a defined period of time and then automatically renews itself for successive periods unless a party gives a notice to terminate the agreement within a certain timeframe. This type of provision has the advantage of the agreement potentially continuing indefinitely with each party having the right to jump off at key points along the way.
Next, the termination right should be spelled out. The agreement should lay out how a party can terminate the agreement early. For many agreements with a drop dead or evergreen term provision, the company often may terminate the agreement early with no adverse consequences only by showing cause – a term that needs to be carefully defined. The employee may want the narrowest definition perhaps limited to criminal or grossly negligent acts while the company may prefer something much broader, perhaps including the failure to adequately perform. Hassling out the details of this cause definition is a major factor in many negotiations involving employment agreements.
On the flipside, the employee often is given the right to terminate the agreement with no consequences only by showing good reason – another key definition. Here, the roles of the parties are reversed. The company prefers a much narrower definition while the executive wants the broadest possible good reason definition. Then it is essential to spell out the consequences of an early termination that does not need the requisite standard of cause or good reason. For the executive, this usually means getting paid without having to work for a period of time, perhaps as long as the original contract term. For the company, it may mean a liquidated damage payment from the executive or other tailored restrictions that are laid out in the agreement.
Next is the work effort. The agreement should spell out what is expected from the executive in terms of effort. Key terms that are often used are full time and best efforts, can the employee moonlight. Limitations on an executive’s off duty recreational and political activities are usually out of bounds, but often it helps to clarify that the executive will do nothing to create a conflict of interest or the appearance of a conflict of interest.
Then there is the issue of prior commitments. A prior commitment provision requires that the executives certify that he or she is not tied down and subject to any contractual commitments that conflict with the obligations to the new employer. An example would be commitments under employment agreements with prior employers. It’s pretty much a must in today’s world to protect the company from a claim that it improperly interfered with an executive’s contract with another party.
In many situations, an arbitration provision is desired. An arbitration provision ensures that any disputes will be resolved by binding arbitration. It offers the opportunity to resolve disputes faster and at less expense. And many believe that an arbitration provision makes it easier to protect the outcome of any dispute.
On the flipside, some fear that an arbitration clause may encourage more claims from employees because of the reduced time and expense barriers. If an arbitration clause is desired, and often it is, take care to ensure that it covers all disputes, binds all parties, and will stay in play even if other parts of the agreement are deemed to be unenforceable for any reason.
Next is protection of intellectual property. The agreement should protect the company’s intellectual property rights. What the company wants to ensure is that IP rights will not disappear when an employee exits. The terms of the agreement should be enhanced by efforts to regularly remind the executives of the provisions in the agreement and other confidentiality covenants, and to adopt company-wide policies for trade secret protection.
As for the agreement itself, usually three elements are essential. One, a clear definition of the company’s rights with respect to existing and future intellectual property. Two, a smart covenant not to compete carefully crafted to reflect appropriate scope, time, and geographic limitations. And three, nondisclosure provisions that prohibit the executive from disclosing or making use of the company’s confidential information.
Finally, there are key administrative provisions that should be included. The agreement should contain a choice of law provision that specifies what state law will apply in the event of a dispute, an integration provision that specifies that the terms of the agreement constitute the complete and exclusive statement of the terms between the parties, and that no other oral or written agreement exists between the parties with respect to the subject matter of the agreement. And three, a provision that lays out how the agreement can be amended to protect against a claim by the employee down the road that some oral statement or course of dealing effectively change the agreement.