When recruiting a senior executive for a portfolio company, much of the negotiation on the terms of the employment contract and the equity incentive arrangements will focus on the terms that apply on termination of the relationship, e.g., the notice period/severance pay, the post-termination restrictive covenants and the leaver provisions in the equity documents. Whilst there are significant differences between the laws and practices across the U.S., Europe and Asia meaning that one size rarely fits all, there are some common themes that can be identified. Careful consideration, at the recruitment stage, of the issues that will need to be faced at the end of the employment relationship will help to ensure that the departure is as smooth as possible.
Notice periods and severance pay
The form of notice periods and severance pay will be driven both by market norms and local laws. In certain jurisdictions, statutory severance payments may be relatively modest in amount and may only apply in limited circumstances such as redundancy (e.g., the U.K.) or be non-existent (e.g., the U.S.). In these countries, an executive may demand long notice periods (e.g., the U.K.) or a lump severance payment triggered by termination by the employer without ‘cause’ or by the employee for ‘good reason’ (e.g., the U.S.). In other jurisdictions, particularly in continental Europe, statutory severance entitlements or those set out in collective bargaining agreements are more likely to have a bearing on the executive’s separation terms. For example, in Italy, it is not uncommon for senior executives to be entitled to generous severance payments and notice periods which are set out in industry-specific collective bargaining agreements, and therefore there may be no need for the executive to request that such protections are built into their employment contracts. Therefore, when entering into new employment contracts with executives, the terms of those contracts should be considered in the context of the wider legal framework in which the employment contract sits.
Protecting the business – post-termination restrictive covenants
Businesses will usually want to be satisfied that post-termination restrictive covenants continue to apply to senior executives who are dismissed and, where enforceable, rely on penalty provisions if a senior executive breaches them. Post-termination restrictive covenants in employment contracts (such as covenants against competing and against soliciting clients and employees) are likely to be viewed critically in the U.S., Europe and Asia, where the courts will seek to balance the business interests of the employer against those of the senior executive but the rules can differ considerably across jurisdictions. It is sensible to include a separate set of post-termination restrictions in the agreement governing the equity incentive arrangements (e.g., shareholders’ or investment agreement) because the courts may be willing to enforce restrictive covenants against individuals in their capacity as shareholders/investors more readily than against individuals in their capacity as employees, who are generally considered to have less bargaining power. It is also common to provide that shareholders’/investment agreements are governed by, say, English law and subject to the jurisdiction of English courts or arbitration, rather than the laws of the country in which the executive works, to provide greater certainty around how the restrictions in such agreement will be judged.
Unlike in the U.K. and Hong Kong, in certain European countries and in China, to ensure enforceability it is either advisable or necessary for the senior executive to receive compensation for some or all of the restrictive covenants arising from his employment. The amount of such compensation (e.g., 20% to 60% of the executive’s pay) will typically be agreed in the employment contract (or the collective bargaining agreement) and is paid out over the duration of the restricted period, although the rules governing the amount to be paid and when payment is to be made can differ quite significantly across jurisdictions.
Leaver provisions in equity documents
Incentivizing executives through equity is a key feature of aligning their interests with that of the sponsor. The structure of these incentives is driven by the country of incorporation of the entity in which they will hold equity and the tax residency of the individuals. While in the U.S. it is more tax efficient for executives to receive stock options or profits interests rather than shares, generally the tax regimes in Europe and Asia means that executives prefer to hold shares.
Amounts invested by those executives alongside the sponsor (as investors rather than employees) will be invested in the same strip of securities as the sponsor, giving them proportionately the same economics. These securities tend not to be linked to employment, so if the executive leaves the securities are retained and sold at the same time as the sponsor. In contrast, “sweet” (or incentive) equity, for which an executive pays comparatively little and which provides the greatest economic upside on a successful exit, is tied to the contribution of the executive to the business. As an executive cannot contribute to the success of the business if he ceases employment, sweet equity is typically given up at that time.
While provisions can be tailored to each circumstance, vanilla leaver provisions would typically include the following:
- Sponsor can choose whether or not the executive has to transfer the securities (i.e., a call option of the company rather than a put option of the executive)
- Good leavers (i.e., executives who leave through no fault of their own, e.g., death, redundancy or serious illness) receive fair value for their securities (vesting over four or five years, with any unvested securities receiving the lower of cost and fair value)
- Bad leavers (i.e., executives who resign or who are dismissed for cause) receive the lower of cost and fair value for their securities
- If fair value cannot be agreed with the executive, an independent valuation is used (to save money, often the most recent quarterly third party valuation of the portfolio company for the limited partners of the sponsor)
- Fair value is calculated at the time the executive ceases employment (although if there are unusually long notice periods, this may be tied to the date the executive goes on garden leave or gives/is given notice)
- Also, in Europe and Asia often the securities are held through an employee benefit trust arrangement (where the beneficial interest is held by the executive, but the legal interest by the sponsor-controlled trust) which makes enforcement easier, although senior executives may push to hold their securities directly.
As well as transferring any equity, it is important to ensure that if an executive is a director or officer of any group company, then he resigns from those positions when he goes on garden leave or ceases employment. When drafting the constitutional documents of the relevant entities, the removal process for any executive who is refusing to cooperate should be controlled directly or indirectly by the sponsor.
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