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Employment Agreements are Essential for Startups & Entrepreneurs

Written by Patrick Henry

Employment Agreements

Discussion of the Importance of Employment Agreements with Jennifer Rubin Esq., Partner at Mintz Levin

“A lifetime contract for a coach means if you’re ahead in the third quarter and moving the ball, they can’t fire you.” – Lou Holtz

In this interview with Jennifer Rubin Esq., a partner at the law firm of Mintz Levin, we discuss the types and terms of various employment agreements and why they are important both to startups as a firm, and to the entrepreneurs and executives that run them.

Patrick:     This is Patrick Henry, the CEO of QuestFusion, with the Real Deal…What Matters. We’re here today with Jennifer Rubin who is an attorney with the law firm of Mintz Levin.

Jenn focuses on C suite executive compensation practices and on meeting the increasingly complex employment needs of executives of public and private corporations. When she isn’t negotiating employment equity and severance arrangements, Jenn leverages her 26 years of experience as a trial lawyer to help clients craft business solutions to legal problems.

She practices law both in California and in New York. Jenn has an AV Preeminent ranking from Martindale Hubbell, which publishes a highly regarded law directory that provides background information on United States lawyers and law firms. That’s the top ranking.

She’s also a member of the board of Big Brothers and Big Sisters of San Diego County. She is a faculty member and advisor to the Honor Foundation, which is another non-profit organization that assists Navy Seals and other Armed Services special operators transitioning from military service to the private sector.

Jenn is frequently quoted in the Wall Street Journal and other publications about employment topics and is a frequent contributor to Mintz Levin’s award-winning EmploymentMatters.com blog. Welcome, Jenn.

Jennifer:   Thank you.

Patrick:     Thanks a lot for doing this today. Today we’re going to be discussing employment agreements, the different types, the key components of each and why they are important for your startup as well as companies and boards of directors. We’ll discuss why they would potentially be important to you as an entrepreneur. Jenn, can you describe to us in layman’s terms the basic types of employment agreements?

Jennifer:   When you think about an employment agreement, it’s really any document that governs the employment relationship. It can also be oral. When most people talk about employment agreements, they’re really talking about a document that provides severance or a term of employment.

Patrick:     Even a job application at the most basic level is an employment agreement because it has some information in there. Once you sign that, that’s a legal and binding document.

Jennifer:   Absolutely. In fact, an offer letter that is provided to an employee that an employee counter signs and sends back is an employment agreement.

Patrick:     That governs the employment arrangement unless there’s something in the state that you’re living in, like Atwell Employment.

Jennifer:   Right.

Patrick:     California is an Atwell Employment state.

Jennifer:   Yes, it is.

Patrick:     Explain what that means. Is that different than other states?

Jennifer:   Every state is an Atwell Employment state. That means that you can terminate someone at any time and for any reason. The issues arise when there are exceptions to Atwell Employment. For example, an employment for a term where you have an employment agreement that says, “I’m going to employ you for a few years.” That’s an exception to Atwell Employment.

Of course, the law places exceptions on Atwell Employment. You can say that an employer can fire someone at any time for any reason. You cannot fire someone for reasons that violate public policy. For example, you cannot fire someone because of their gender or age. There are a lot of exceptions to the rule. In effect, that is the law in California, as in most states.

Patrick:     That’s why there has to be some documentation. If you’re dealing with an accepted class or a protected class.

Jennifer:   But there really doesn’t have to be documentation as to that because the law itself provides the documentation.

Patrick:     If you’re an HR professional in a company, you need to make sure that you understand all of those things. If you do make a decision to terminate someone, you need to be in compliance with all of those things.

Jennifer:   Exactly.

Patrick:     With employees, I’ve seen these proprietary information and invention agreements. What are the key terms of those? I’ve been mainly working in engineering companies. I’ve spent most of my career developing complex technical products. There is a lot of intellectual property. These are the types of things that I’m familiar with. For the rank-and-file employees, can you talk a little bit about that?

Jennifer:   It’s important when you bring someone into your organization and they’re going to be exposed to your confidential information and trade secrets that you protect that, both while they’re employed and after they’re employed. The proprietary information relates to confidential information. It might relate to trade secrets.

It’s important that it’s clear to the employee what’s yours as the employer and what they can and cannot use with respect to that information. Inventions is slightly different. You’ve been in an engineering company. The important issue there is that, if someone is working on your invention, you want to make it clear that it’s the employer or the organization that owns the rights to that invention.

That’s where those agreements become very important. You want to make clear, “You’re coming into my organization. I’m paying you to work on my product, invention or development. I own that. After you leave employment, there’s no issue or ambiguity about who has the rights to that invention.”

Patrick:     This has been important in my experience, not only with employees but also with contractors. Especially in the engineering world, there are specialists that work in a particular area. They are hired guns, so to speak. You bring them in because they may have a specialty in a particular area. You don’t need them long term but you need them for a particular opportunity. Making sure that you get the proper documentation in place and it’s clear as to who owns what is really important.

Jennifer:   Absolutely. Making sure that you have signed agreements is one of the biggest mistakes I see. You may have a great form agreement. You may pay counsel to prepare this wonderful form agreement. But then you have people coming in and you don’t have good internal organization from an administrative standpoint. You’re not actually collecting signed agreements, filing them and keeping them on hand in case you need them.

Patrick:     I’ve seen this, primarily in M&A transactions. I’m with a company. We decide to buy a smaller company. They haven’t done a great job of this. We’re really concerned about it. Did they even own the intellectual property that was developed? In some cases, it’s been a show stopper if the smaller company hasn’t put those things in place.

Jennifer:   That’s right.

Patrick:     It’s very important for entrepreneurs to make sure that, if you are developing anything, you do get these agreements in place, even with contractors. Are there other key terms and employment agreements that a founder of CEO of a startup needs in his or her employment agreement?

Jennifer:   One of the things that founders in particular need to be concerned about is that you’ve birthed your baby, so to speak, and now you’re fostering it. You’re bringing in outside investment to help bring it along with the hope of an exit. That’s the general business plan.

The problem arises when outside investment comes in and, for one reason or another, they may decide that you are no longer the key leadership that they want. From a founder’s perspective, you want to get in writing what’s going to happen if you are asked to leave for some reason. You’re fired, in effect.

That’s the importance of employment agreements from a founder’s perspective, or any executive. What are the financial terms upon your departure? Having that in writing is critical. That’s not anything that the law is going to supply to you. That’s something that you need to have in writing, signed by both you and the company. It’s very important for an executive who might be giving up other opportunities to come and work in a certain company or a founder who is trying to get things moved along.

You want to make sure that you understand what’s going to happen if you’re terminated. It’s the same thing in terms of what happens to the equity. You may have options that might vest or restricted stock that may have restrictions that would lapse upon certain events. It’s very important to get that in writing.

Patrick:     I’ve worked with a lot of venture capitalists over the years. They have their own pithy statements about this stuff, like putting the founder in another area code. CEOs come and go. I don’t have any hard statistics on this. In your vast experience in this, how often do founders end up getting removed from their company? How often do CEOs that get hired into a company get removed? Is it pretty high?

Jennifer:   I would have no idea what the statistics are. I do work both with companies and with executives. It’s fairly common to see interests diverge at various points in a company’s growth. A company may start out in a certain direction. There may be new money coming in that takes it in another direction or an acquisition. It’s very hard for me to answer that question.

I will say that you’re in a better position if everyone knows what’s going to happen upon that exit. I see employment agreements as the primary vehicle for determining the financial issues when an executive leaves.

You know in advance, is it a year’s severance? What’s going to happen with the stock? It gives both board and executives that pre-knowledge about what will happen upon an event of termination.

Patrick:     I agree 100% with that. It’s interesting. I think any time that you raise an institutional round of financing, like a Series A, and you bring venture capitalists in, if you’re a founder of a company, you need to get these things put in place. There have been times in my career when the VCs have said, “Just trust us.” My answer is, “This isn’t a matter of trust.

This is a matter of clarifying how things will work in the event that things go sideways.” If I didn’t trust you, I wouldn’t even work with you. You wouldn’t ask me to sign a proprietary invention non-disclosure agreement unless you trusted me. It’s not really about trust.

I think that’s a negotiation tactic that people use. If you’re a founder or a CEO, sometimes it’s very difficult to negotiate for yourself. Even if you’re a fantastic negotiator with customers, it’s really important that you get these things put in place. Although Jenn wouldn’t give us statistics, it is common for these things to happen.

The time to negotiate these things is not as you’re being exited. The time to negotiate is when you’re bringing in an institutional round of financing if you’re a founder or when you’re negotiating coming into a company if you’re the CEO that is being brought in.

Jennifer:   That’s right. Think of it this way. You can’t submit a handshake as Exhibit A at trial.

Patrick:     Let’s look at something near and dear to my heart since I’ve been a CEO at three different startups and a C suite executive before that at some technology companies. Talk to us about employment agreements in more detail with entrepreneurs and executives. This is one of the big secrets in companies. You don’t even know that these things exist until you get to a certain level.

Maybe if you’re a first-time founder, you don’t know that these things exist. I would say that it wasn’t until I negotiated my third startup that I had any idea what I was doing. There are so many intricacies to these things. I think it would be really instructive for the entrepreneurs out there.

Give me a perspective since you work with boards and executives. What are the big terms that are important in these things for both sides?

Jennifer:   I think the most important issue is what happens upon an exit. There are other things that you can have in there, like benefits, salary and bonuses. Those things are important. They’re material terms of an employment agreement.

But everyone needs to know what happens when either the founder is asked to go or forced to go, or when the founder wants to go. Those are really important issues. When I say founder, I also mean executives. Then you know what’s going to happen. There are severance terms. They are very important.

Even more important is the definition of cause. There is no standard definition of cause. There is no commonly accepted definition of cause. This is something that’s typically subject to negotiation. It implies misconduct. That’s a very good starting point. What is misconduct?

Of course, the company would like to have a very robust view of that and the executive would like a very narrow view. It’s about meeting in the middle. If and when it comes time for the executive to go, the issue is going to become, “Is it with cause? Is it without cause? What do we have to pay this person as a result?”

Patrick:     Cause is the reason for dismissal. In my experience, that has been one of the more difficult things to negotiate, especially if there is a performance element associated with the cause. Is there a notice period? As an executive, I’m totally fine with someone saying, “If you’re not doing your job, I have the right to dismiss you without paying you severance.”

I’ve never had an issue with that. My attorneys who defend me say, “You don’t want that in there because it opens the door for manipulation.” Everything I’ve had has that portion in there. The board has to give you written notice of the issue in advance. Then you have some type of cure period.

With all of the deals that you’re negotiating, do you see that there are situations where there is no performance portion for cause? Are there people who are brought in with nothing in there like that? Is that a standard term?

Jennifer:   I don’t think there is any standard term when it comes to cause. I think it’s very wide open for negotiation. It typically implies a concept of misconduct. It is very common to ask for some sort of notice.

From a perspective of fairness, tell the person, “We don’t think you’re doing a good job. This is how you need to improve. You’re going to have a certain period of time to improve. If you don’t, you’re going to go and you don’t get severance.” You can think about that from a fairness perspective. But it doesn’t always work that way.

Patrick:     The attorney that I worked with was a hardcore guy. He said, “Unless you get convicted of a felony, that’s the only reason that should be cause.” Obviously, the board took a different view upon those things. There was negotiation that occurred. What turned out was fine with me. You’re making a decision as an executive if you’re leaving a company.

You’re leaving money on the table. That’s the time to make a decision. Am I getting a deal where, “I’m going to take this thing out of the garbage to a successful company or something that is pre-product to something that’s a successful company.” It’s primarily equity-based compensation.

You might get some cash compensation, but the primary reason why you move from a big company to a small company is because of the equity. You want to make sure you get that in the event that you’re successful and that it doesn’t get thrown out with the trash. I think this is important. Cause is clearly a key element.

As a guideline for the entrepreneurs out there, do you have a checklist of things they should think about? Is it so wide open that you can’t do that?

Jennifer:   It’s very wide open. Of course, when I’m engaged either by the board or by the executive, I approach it very differently. Typically, it’s the company that presents the draft agreement to the executive. Then the executive negotiates against that. It’s very hard to answer that question because my approach to it would depend upon who I’m representing. Am I commenting against the draft? There are all of those other things that come into play, like how badly the company wants the executive. What other opportunities is the executive giving up? The negotiating leverage is so different in every situation that it’s very hard to answer that question.

Patrick:     If you are an executive, having the conversation about working for a company, especially a startup, these are not things that you want to bring up on the first interview.

Jennifer:   Yes, that’s true.

Patrick:     I think these are things where you want to wait until they really want you, they’ve presented you an offer and they’re courting you. That’s the time to start having some discussions around this. Otherwise, you can really shoot yourself in the foot and look unreasonable and greedy.

Tell me a little bit about change in control provisions. First, what’s the difference between single trigger and double trigger in change of control?

Jennifer:   A single trigger change of control is when there is an exit in effect, whether it’s an asset purchase or stock purchase. It is a defined situation usually when a company is acquired. A single trigger means that, upon the happening of that event, the executive gets to parachute out.

I haven’t seen a single trigger change of control provision in a very long time. As you can imagine, they’re disfavored because it may be that the new company coming in making the acquisition wants the management team to stay. It almost becomes a disincentive. That’s becoming unusual.

A double trigger is when there is this transaction or exit. Within a certain defined period of time, the executive is terminated. At that point, the executive gets to parachute out with certain benefits, whether it’s equity acceleration or a more robust severance. There has to be that two-step process. There has to be the transaction and then the exit associated with the transaction.

Patrick:     In one of my companies, we negotiated two different definitions of cause. One dealt with the stand-alone company and one dealt with, in the event that there was a change of control, the definition of cause changed around that. Do you see that as common?

Jennifer:   I have not seen that. I could definitely appreciate and understand why that would come into play. Of course, the new owners coming in may have their own team. That’s fairly common. No one thinks that’s unusual. You want to provide that protection for yourself.

Patrick:     I’ve always had a dual trigger. But when we had a private company, my dual trigger was that there would be the change of control. Then I had to lose my position in terms of basic scope. If I were a general manager for a bigger company, that’s not a double trigger, even though I was the CEO of this company over here. In the situation when I had a public company, then that second trigger was changed that, if I was not the CEO of the successor company, then my second trigger came in. Do you see that as being common?

Jennifer:   What you’re really referring to is a good reason provision that allows you to parachute out if you don’t maintain your position within the organization. That is something that is extremely common. If you think about it, you’ve achieved a certain level as an executive and you’re entitled to maintain that for purposes of your own career. If you’re all of a sudden asked to step down several steps, you should be entitled to say, “I don’t want to be at that level in the organization. It’s time for me to go.”

Patrick:     I wasn’t the only one who had stuff like that, for instance, people who were like my general counsel, CFO and head of HR. But people who were in marketing or sales positions had more of the standard double trigger as opposed to what I would call this special double trigger where you didn’t keep your exact title.

Jennifer:   There is one thing that I want to add. This is very important overall to everything relating to employment agreements and change of control. There are certain tax provisions that are implicated in these agreements.

Patrick:     These are parachute payment type of tax situations.

Jennifer:   There is that, too. That is 280G of the Internal Revenue Code. I’m referring to Section 401-9A, which is another provision that penalize executives pretty heavily if an agreement is not compliant with the tax code.

My general advice, when you’re entering into an employment agreement is to either engage employment counsel with tax expertise or separately engage an accountant. If your agreement doesn’t comply and then it turns out later that you’re triggering something, you could create a major problem for yourself. This is another reason to never cut and paste an employment agreement from someone else and sign on to it.

Patrick:     It’s worth it to spend the money on a competent attorney in terms of the technical aspects but also the negotiation. You’re dealing with seasoned professionals on the other side.

Jennifer:   That’s right. When you’re talking about perhaps a 20% penalty, that’s not just tax. That’s a 20% penalty on all amounts that you receive that are deemed by the IRS to be non-compliant, I would think that, compared to a couple thousand dollars to hiring competent counsel is worth it. You don’t want to learn that after the fact.

Patrick:     That’s terrific advice. What about acceleration in equity? In my last public company, I saw a survey from one of these compensation experts. They said that all C suite executives are getting full acceleration on change of control in public companies. That hasn’t been my historical experience.

Typically, the founders or the CEO get full acceleration. Everyone else gets either 50% or 24-month acceleration. I was surprised to see this. Is there a difference between private companies and public companies here? What do you see as the common thing going on right now?

Jennifer:   I think the most common thing that you see is a full acceleration with change of control. There are different issues with private companies and public companies, obviously related to marketability. With a private company, you can’t necessarily sell the stock on the open market.

There are also issues associated with the 280G that I just mentioned, which is the parachute tax. That is what happens when the individual parachutes out and receives all of this compensation that might trigger those tax provisions.

With a private company, there are certain ways that might be able to be dealt with that addresses the tax situation, that is not available in a public company situation. If I was representing an executive, I’d like to see full acceleration. That’s what I would argue for.

Patrick:     But it would be dual trigger.

Jennifer:   Yes, it would be dual trigger. Again, I can’t remember the last time I’ve seen a single trigger. You want to negotiate for that acceleration and connection with the change in control because that’s the whole point. You foster this organization. You take it to that point. The new company comes in. They’re either buying all the assets or the stock. That’s the point of you staying and remaining incentivized to stay. It’s so that you get the benefit at the end. The way to get the benefit is through the equity.

Patrick:     Do you see 100% acceleration across the board with termination without cause or termination for good reason? Or is that not necessarily 100% acceleration in those cases?

Jennifer:   I would almost always see 100% acceleration in those cases. At least, that’s what I try and negotiate for when I’m representing executives.

Patrick:     That’s not uncommon in your experience to be able to get that?

Jennifer:   Absolutely.

Patrick:     Again, this is valuable information for entrepreneurs and founders out there. Let’s talk a little bit about where non-competes come in. Why are they significant here in California?

Jennifer:   Non-competes are significant here in California because they’re illegal unless someone is selling all of their equity interest in a corporation, which makes sense. If I’m coming in to buy a company, I shouldn’t allow the individual who owns all the stock to, the next day, open up business across the street from me.

There are some very limited situations where non-competes are enforced, and that’s one of them. You have to sell all of your equity interest in the company. The company buying it has to be in that business. Every other type of non-compete is illegal in California in every situation.

This is not just non-compete in terms of, “You can’t be in a competitive business.” It also prohibits a company from asking an individual not to solicit the company’s customers after the individual leaves employment.

Let me make one thing clear. While you are employed, the law says you cannot compete with your employer. This relates to post employment activity. What happens when you’re no longer employed? That’s when the ban on non-competes comes into play.

Another important exception is that trade secrets are protected in California. You are not allowed to use someone else’s trade secrets after or during employment. That’s another exception to the non-compete rule. I say this from practicing in New York for 25 years and then moving to California a couple of years ago.

It’s my experience that there are many companies and executives who are unaware of this ban, who come into California, engage executives here or buy companies here and they don’t even realize that there is this law on the books here in California. It is truly amazing to me how many people are completely ignorant of that fact.

Patrick:     Most companies, including small tech and internet companies, are global or nationwide in terms of their presence. Let’s say I’m physically employed in California. I open up a shop and I’m doing business in New Jersey or some other state that doesn’t have this restrictive situation where you can’t have a non-compete.

Can a company that I’ve sold my company to come after me and say, “Even though you’re living in California, you’re doing business in New York or New Jersey. Therefore, you’re violating some kind of non-compete that I have with you?”

Jennifer:   The question you’re asking comes up almost every day. I can’t give you one straight answer on it. If you are domiciled in California and you have the protection of California law, you have a very good argument that enforcing that provision anywhere in the country is a violation of California’s public policy. Therefore, it should not be enforced. It can lead to some very complicated, lengthy and expensive litigation.

Patrick:     Has there been any case law established around these kinds of things?

Jennifer:   Yes. There is a substantial amount. That’s another video for you.

Patrick:     Tell me a little bit about severance, continuation of salary or lump sum payments. What are the severance provisions that you normally see today for founders, CEOs and C suite executives?

Jennifer:   There is no one formula that I see. Generally speaking, a year or less is the maximum that you typically see. What is severance? Severance is entitled to provide income replacement in the event you suddenly have a job loss.

It’s not intended to benefit you financially or provide a tremendous amount of money in your pocket. That’s where the equity acceleration comes in. That’s why you get involved in startups. That’s where the financial value is. Severance is intended to give you a little bit of cushion while you go out there and look for a new job.

Patrick:     Six months to a year is pretty common?

Jennifer:   Yes, generally speaking. One thing I am seeing a lot of these days is severance only kicking in after a certain period of time. The executive has to come in and prove their worth for a couple of months. After they’ve been with the company for a couple of months, at that point, if they’re terminated, severance might kick in.

Whether it’s six months or a year, it makes sense. It gives individual and companies a time to get to know each other. It’s like an extended job interview.

Patrick:     As an executive, especially if you’re leaving a high paying executive position at a larger company and you’re coming into a startup, you really have to be careful about how you negotiate those things. Let’s make sure we really know each other before we get into this arrangement so that I don’t put myself and my family at risk by coming into this deal. What about other goodies, like health benefits or Cobra payments? You get your personal computer.

Jennifer:   Typically, on the Cobra payments you would negotiate that. The company would provide the same level of health insurance that you would have from a financial perspective for the duration of your severance. That’s a starting point. The cost of monthly health insurance is extremely high and rising. This becomes a subject of negotiation. There may be certain tax implications as a result. That’s something else to keep in mind.

Patrick:     Tell us a little bit about yourself and what you do for fun, other than being a litigator.

Jennifer:   Trial practice is the best part. I moved to California from New York a couple of years ago. I had taken full on the California lifestyle. I enjoy surfing, paddle boarding, sailing and most particularly, taking my dogs to Dog Beach. I think that’s purely a California thing and it’s totally enjoyable.

Patrick:     It’s clear to me that employment agreements are critical. My experience is that you get one chance to get it in place. I think you really need to get a competent attorney to help you negotiate them and also to make sure that you’re in compliance with all the tax provisions.

This is something that, as an employer, you want to have with all of your employees. As a board of director, I think it’s important to have these things up front with your executives so that you have clarity if you’re investing in companies with the founders so that everyone knows what’s coming. Is there anything else that you’d like to add that you think is critical?

Jennifer:   My one word of caution is not to take your friend’s employment agreement and insert your name and terms. More and more these days, it’s very important that you have a compliant employment agreement. You do not want to find out later that you do not. It actually cannot be fixed. That’s my warning.

Patrick:     It’s not just tax. It’s penalty associated with it.

Jennifer:   Exactly. This happens every couple of months. Something comes across my desk and someone says, “Can’t we just amend it?” The answer is, no, you can’t amend it in many circumstances. That’s my word of caution. Get that advice up front before you sign.

Patrick:     I want to thank you, Jennifer, for being with us today. This has been really informative and educational. I hope it has been valuable for the entrepreneurs out there. This is Patrick Henry, the CEO of QuestFusion, with the Real Deal…What Matters.

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This is Patrick Henry, CEO of QuestFusion, with The Real Deal…What Matters