12 / 15 / 2017

Executive Compensation and Severance

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Once the exclusive domain of major publicly traded companies, complex executive compensation issues now arise regularly in privately held companies, from family business organizations to tech startups. If you’ve reached a certain point of your career, you may find yourself enticed to join a new company or even stay at your existing one by an incentive and retention plan like this.

Broadly, most such plans give you either a way to acquire equity in the company or earn bonus cash, plus certain rights if the company undergoes certain changes affecting your job. The point of the package is to back up statements about a long, rewarding career with real contractual covenants. Typically, these include severance rights –basically rights to collect a cash-out of some of the above rights if you leave employment either for the company’s convenience, or if you have a defined “good reason.”

Having an incentive or retention package with a severance component can be a great thing for someone looking for long term stable employment in which the rewards accumulate over time. Lately, however, we at VLF have seen a number of our executive clients, many of whom may have relocated to Texas on an incentive package with a severance component, face some really difficult issues when the time comes to exercise severance rights. Here are a three of the types of questions we have seen arise often, and a couple tips on what you might ask if you find yourself in this position.

  1. What do you actually have?

    1. Stock Grants & Options,: Usually, an incentive plan will vest over time, either automatically granting you equity (i.e., shares or units) in the company, or giving you the right to buy such interest at a reduced price. In the case of a steadily growing company trying to hang onto a high achieving executive, stock grants typically vest over time to give the recipient “sweat equity.” In the startup or early stage context, the deferred stock option arrangement is often couched as using tomorrow’s bonus to later buy in at today’s share price.

      In either case, you need to understand what class of shares or membership units you are getting. If your shares are granted as a percentage, you need to ask the question, “a percentage of what?” Many companies make distinctions between voting and nonvoting shares. Some are more subject to dilution by outside investors (See, eg., the plot of the movie The Social Network). Others have shares with preferred distributions, the payment of which can affect company valuation and growth opportunities. Others may have different restrictions on transfer. All of these provisions can affect stock value.

    2. Mandatory stock buyback provisions: along with the grant of stock or options, there is often the provision requiring a departing executive to sell his or her shares back to the company upon termination of employment. The price for the returned stock may be subject to mutual agreement, stated formula, or third-party valuation.

    3. Phantom Stock: Favored by larger and multinational companies, a phantom stock grant essentially is an account that tracks the value of the shares you would have earned on a vesting schedule, then tracks the value of the shares over time, and then pays you the difference in cash upon termination of employment. In essence, it is like a back account that automates the share issues and buyback. Note that although no equity technically changes hands, typically, phantom stock holders have similar rights to inspect books and records as actual equity holders.

  2. How can you trigger the most beneficial severance?

    1. Good Reason”: Typically, an executive compensation package to treat the departing employee differently if he or she is leaving, a) for employee’s defined “good reason” or at the company’s convenience, vs b) for the employee’s convenience, vs. c) for cause. Generally, the package is most favorable to employee in situation a and least favorable in situation c. Disputes over whether or not “good reason” exists can be protracted, and many are avoidable with well-crafted contractual clauses.

    2. Change in Control provisions: A common element in the definition of “good reason” is a change in control (“CIC”). This can be defined in many different ways, but the most common focus on sale of the company or its assets to another party, movement of the office from the employee’s residence by a prescribed distance, or material change in the employees job description and managerial control. For high achieving executives looking to maintain their lifestyles and control over their futures, a carefully defined CIC can be critical, both at the time of embarking on a new job, and at severance.

    3. Questioning the Books: If you hold equity, keep in mind that irrespective of rights of voting and CIC issues, you will have certain rights to inspect the books and records of the company. From a severance perspective, this means that if you believe the price the company wants to pay to buy back your shares is unreasonable based on what you know to be the actual profitability of the company, you have a right to the information that would help you make such a case. These sorts of disputes can lend themselves well to third party valuation.

    4. Fiduciary Duties and Profitability: Fiduciary obligations comprise many complex issues covered in various other parts in VLF’s blogs. However, in the compensation and severance context they can have particular importance where the employee holds equity in a subsidiary, and there are concerns that the majority owner parent company is stacking the board of directors to run the subsidiary for the corporate parent’s benefit rather than to maximize profits for subsidiary’s shareholders. While in Texas, the Ritchie v. Rupe decision vastly weakened the common law shareholder oppression remedy, it is important to remember that the subsidiary’s board of directors can still owe fiduciary obligations to the company and to the shareholders subject to the business judgment rule. If you believe the company in which you earned shares is now being run sub-optimally for the benefit of the controlling directors, this can be something worth exploring. 

  3. What’s limiting you?

    If you are leaving a job that has provided a lucrative compensation and severance package, chances are you have certain obligations that prevent you from instantly using your knowledge to compete directly. It is critical to review the very contract documents that have been the basis of your remuneration.

    1. Confidentiality: As the sort of executive in a position to get retention, incentives and severance, you are likely privy to proprietary information, trade secrets, and other confidential information that you will have either expressly or by operation of law agreed to keep secret. Know that these obligations survive the termination of employment, and your former employer would be able to enjoin any improper disclosure by court order, and seek damages. Look through some of VLF’s other blog entries on this complex subject.

    2. Non-Competes: Texas used to have a reputation for not enforcing non-competes, but the situation has changed in the last several years. Your contract will likely state that the company has invested a lot in you and entrusted you with certain knowledge so that it there is a pro-competitive reason to protect that investment and trust by keeping you out of competition for a reasonable time, within reasonably circumscribed geographic and subject matter markets. Courts scrutinize such clauses and will invalidate or trim back anything overreaching; employers with knowledge of Texas law will know not to overreach as otherwise they can face the risk of paying the attorneys’ fees of a departing executive who successfully challenges them.

    3. Anti-Poaching: Often, as a departing executive, you are contractually obligated to not take company employees and customers with you. Like non-competes, such clauses are scrutinized by courts for reasonable limits on scope, geography, and time, and will often be cropped back to reasonable contours if they overreach.

This overview is intended as general information on the subject only. If you would like to know more about the tailored counsel that we at VLF can provide for your specific executive compensation or severance situation, please do not hesitate to contact us directly.

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