Hiring and retaining capable executives who can drive performance is a top priority for most any business. Companies should want to incentivize management employees to meet their goals and, at the same time, protect themselves from poor performance or incidents of misconduct. Talented executives with coveted skills and experience have their own expectations and requirements concerning compensation, performance criteria, benchmarking, etc.
To maintain the proper balance between the interests of the company and the executive, drafting effective employment agreements for key personnel is essential. While not an exhaustive list, below are five important aspects of executive employment agreements that will nearly always warrant consideration during the negotiation process.
1. Protect the Company’s Confidential Information and Property
Senior management employees typically have access to sensitive financial and business strategy information that could harm the company if used improperly or if disclosed to the market or particular competitors. While businesses have some degree of protection from misuse or misappropriation of their confidential information and property by virtue of the common law duty of loyalty and statutory trade secret protections, the executive employment agreement should also contain terms outlining the employee’s confidentiality obligations.
The company should describe with specificity the sort of information it considers confidential so that there is no ambiguity regarding what the executive is allowed to disclose or use outside the company, both during and after employment. The agreement should also emphasize that such confidential information belongs to the company exclusively and must be returned upon termination of the executive’s employment. Including confidentiality obligations in the employment agreement, along with enforcement mechanisms in case of a breach, is often a more efficient and effective means of protecting the company’s secrets than relying upon the employee’s common law or statutory duties.
2. Restrictive Covenants Are Important, But Should Not Overreach
Given the investments companies make in their executives, as well as the insider knowledge and customer relationships developed by members of management, businesses have good reason to protect themselves from competition on the part of such employees. In most states, courts will uphold non-compete clauses in employment agreements, provided the restrictions are reasonable, as viewed from the perspective of the employer’s legitimate business interests, the employee’s need to earn a living and public policy concerns. The reasonableness of the provision’s functional and geographic scope, as well as its duration, are key considerations.
Even in jurisdictions that allow non-competes, the level of scrutiny imposed upon such clauses varies greatly — for example, in some states a court may have the ability to “blue pencil” an overly broad restriction to make it reasonable, whereas in other states, such a restriction would be grounds for invalidating the entire non-compete. Companies should therefore consider adopting a choice-of-law provision that will govern the contract’s interpretation, ideally naming a jurisdiction that has upheld language comparable to that used in the agreement. Of course, the jurisdiction selected does need to have a reasonable nexus to the parties to the agreement.
Regardless of what a state’s law governs, companies should resist the temptation to be overly aggressive in creating post-employment restrictions, instead tailoring their clauses to address concrete and reasonable business concerns. Doing so will help avoid the risk and expense of litigation by departing employees who seek to restrict or invalidate the non-compete.
In evaluating their legitimate business needs, companies should also consider whether milder restrictions, such as prohibitions on the solicitation of customers or employees, would suffice, for such terms are easier to enforce and are less likely to be challenged by the employee.
3. Set Clear Grounds and Procedures for Termination of the Agreement
Many executive employment agreements are for a set term, often with a mechanism for renewal. In such cases, the company should, at a minimum, include a provision allowing for the agreement to be terminated early “for cause.” Typical grounds for termination “for cause” include certain criminal convictions, dishonesty and uncured performance issues — to name a few.
The company will generally have an interest in creating broad and subjective categories of “for cause” conduct that will capture a wide array of potential behaviors, while the executive will typically want to narrow the categories so that only specific actions amounting to serious misconduct will trigger the provision. Effective employment agreements strike the appropriate balance between protecting the company from employee misconduct and providing reasonable job security for the executive.
As a parallel to “for cause” termination on the part of the company, some employment agreements provide the executive with the ability to terminate early “for good reason.” Such reasons will vary according to the parties’ needs, but can include reduction in compensation, sale or change of control of the business, changes in job duties and uncured breaches of the agreement on the part of the company.
These clauses are often drafted into agreements for the purpose of establishing a right on the part of the executive to claim a severance payment from the company in the event that the employee terminates on the basis of a “good reason” as specified in the contract.
It is also common for executive employment agreements to contain terms allowing for early termination upon a specified amount of notice (30 days, 90 days, etc.). The notice periods provided for in the agreement are subject to negotiation and typically depend upon the bargaining power of the respective parties. In most cases, for a termination-upon-notice provision to be acceptable to an executive with sufficient negotiating leverage, a meaningful severance payment by the company will be required.
4. Consider an Appropriate Severance Payment Upon Early Termination
When an employment agreement is structured so that it can be terminated early by the company without cause or by the executive for good reason, a severance payment is typically involved. Awarding severance in such situations is a normal cost of recruiting top talent who have other options and want financial security in the event that their new role does not play out as envisioned through no fault of their own.
The negotiating points center around the amount of severance and how it is structured — e.g., a lump sum or salary continuation for a set period. As severance can be considered deferred compensation that is subject to the requirements of Internal Revenue Code Section 409A, the parties must be careful to structure the payments to comply with the rules or risk incurring additional taxes.
5. Create Compensation Structures that Reward Strong Performance and Loyalty
Recruiting top talent and keeping them performing at high levels for the company often requires compensation beyond a competitive base salary. There are a variety of options to consider, depending on the circumstances. For example, many executive employment agreements provide for bonuses to be paid, either at the discretion of the company based on subjective performance or upon the employee meeting objective performance targets, such as revenue or net income goals. Fringe benefits, including use of company automobiles or payment of club membership dues, are also sometimes offered as incentives for high-performing executives. Stock options whereby an executive can receive the ability to build an ownership stake in the company should also be considered.
While these are but a few examples, the most effective employment agreements use such compensation – structured wisely to avoid unwanted tax ramifications – to promote performance and maintain loyalty to the company.
Carefully crafted executive employment agreements are crucial to the relationship between companies and the management personnel who drive their success. Thoughtful consideration of the goals and ramifications of the provisions being negotiated is paramount. Competent counsel experienced in employment and compensation law can help to maximize the value of executive employment agreements for all concerned.