In Part VI of this series, we discussed the intricacies of negotiating the SHA in the context of VC funding. In this part, we deal with negotiating the executive employment agreement (EEA). The EEA outlines the terms of employment for founders – including their roles, responsibilities, compensation, benefits and termination provisions. Founders must carefully negotiate their EEAs to ensure they are in harmony with their startup’s growth trajectory while also meeting the VC fund’s expectations.
Designation and Commencement Date
Founders should ensure that the EEA accurately reflects their designated roles – such as CEO, CFO or other key positions – as it defines their authority within the startup’s hierarchy. A well-defined role also provides protection against any future legal disputes regarding decision-making powers or while performing regulatory compliances. Further, executive designations help establish a stronger negotiation position in board dynamins at a later stage, which is especially important as the company scales.
Additionally, specifying the date on which they assumed these positions is important for documenting various aspects such as vesting schedules, tenure for calculating beginning of non-compete clauses etc. In fact, often severance packages or termination benefits may be tied to the founder’s official start date. The commencement date could also affect statutory employment benefits under labour laws. Hence, this clarity ensures that both the founders and the VC fund are aligned on the terms of founders’ employment.
Compensation and Benefits
Founders should carefully consider their compensation package, balancing their financial needs with the startup’s financial health. This includes salary, benefits and any other performance-based incentives, ensuring they align with industry standards and VC fund expectations.
This aspect holds significant importance as post-investment by the VC fund, founders’ shares are typically locked in, limiting their ability to sell shares for a specified period. VC funds are often particular about compensation, ensuring it reflects the startup’s business size and is not perceived as misallocation of investment. At the same time, founders should try to negotiate a fair compensation amount for their role since they would usually be prevented from engaging in any other form of work that could generate any additional income for them. VCs would typically only allow founders to make passive investments and not permit any active role in any other business. To that extent, founders may need to rely on the income from their start-up as the sole revenue source for their livelihood.
Vesting of Shares
Vesting of shares refers to the process by which founders gradually earn ownership of their shares over a specified period, typically contingent upon their continued involvement with the startup. In VC deals, investors typically require founders to adhere to a vesting schedule, which can vary from a more favourable monthly, quarterly or annual release of shares. Negotiating for monthly vesting allows for a steady release of shares each month over a 3 to 4-year period. While it is common for investors to subject 100% of founder shares to vesting, founders should aim to negotiate and limit this to 70 to 75% to retain some ownership control.
Termination Provisions
Understanding vesting is vital as it directly correlates with termination, a clause crucial and often heavily negotiated in most deals. These provisions outline when a founder’s employment can be terminated and how it impacts their vested shares. Termination can occur for various reasons, categorized into buckets such as ‘cause’, ‘good reason’, permanent disability or death, as well as voluntary resignation or termination for any other reason. Each of these scenarios affect the vested shares of the founders differently. Negotiating these terms depends on the specifics of each deal. However, to provide some reference, we have outlined below the impact on vested shares in each scenario – aiming to strike a balance between founders and a VC fund.
- Termination for Good Reason: Founders should negotiate for a ‘good reason’ clause, enabling them to retain all shares (both released and unreleased) in case of them being terminated because of a good reason such as due to a material demotion in role, a significant reduction in compensation (e.g., by 50% or 75%) etc.
- Termination for Cause: ‘Cause’ generally encompasses reasons such as acts of dishonesty, fraud, involvement in unlawful activities, crimes involving moral turpitude, wilful misconduct, gross negligence etc. Upon termination for ‘cause’, released shares may be bought back or transferred to an ESOP trust at fair market value (or at a discount to fair market value), while unreleased shares may be bought back or transferred to an ESOP trust at face value. However, where cause involves fraud it is common that the document provides for all shares to be purchased for face value.
- Cessation of Employment on Account of Voluntary Resignation or for Any Other Reason Other than Cause or Good Reason: In such instances, founders should retain their released shares, while unreleased shares may be bought back or transferred to an ESOP trust at face value.
- Termination in Case of Death or Permanent Disability: This scenario may trigger accelerated vesting of 100% of unreleased shares. If the founders / successors decide to sell all shares, the startup may buy back or transfer them to an ESOP trust at fair market value.
It is important to negotiate fair and objective thresholds for ‘cause’ and ‘good reason’ events. This list requires careful review by founders, with objective thresholds set for each instance. Mere suspicion or subjective judgment should not be the benchmark for determining ‘cause’. Process for determination of ‘cause’ is often a contentious issue. A VC fund would typically prefer the board to decide (without founder directors involved), while founders would argue that the board may not be the most suitable forum, especially given the gravity of such decisions. As a middle ground, determination by an independent third party following fair and impartial principles of determination is often seen as a balanced approach, ensuring fair consideration for both VC funds and founders.
Non-compete and Non-solicit
These clauses restrict founders from engaging in business activities that compete with that of the startup or soliciting employees of the startup for a specified period after leaving the startup. Founders should ensure that these restrictions are reasonable in scope and duration and allow for standard exceptions, such as investing in listed companies, mutual funds or businesses that do not compete with the startup.
A standard non-compete period is usually 2-3 years after the founder stops holding shares or working for the startup, whichever is later. Founders should aim to reduce this to 1-2 years through negotiations.
By negotiating these agreements thoughtfully, founders can protect their ownership interests and ensure a fair outcome in the event of employment termination. Founders should seek to strike a balance between protecting their interests and aligning with the goals and expectations of the VC fund. By understanding these key points, founders can navigate the complexities of executive employment agreements and lay a strong foundation for the growth and success of their startup.
With this article, we have covered in general the important transaction documents in a VC transaction. From our next article, we will shift focus on specific negotiation points under each of these documents. We will attempt to list out the negotiation stance of a founder and VC in each case and the balanced position that can be considered. That said, the eventual position on each point will depend on the bargaining position of the founder or VC depending on the then prevailing market environment and business of the start-up.
Pooja Agarwal | Senior Associate; Ajay Joseph | Partner
Views expressed above are for information purposes only and should not be considered as formal legal opinion or advice on any subject matter therein.