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You've negotiated debt covenants, mergers, and supply contracts — but do you know what should be included, and struck, from your employment contract?
Marie Leone, CFO.com | US
June 23, 2008
Among the first things to think about when reviewing a new job offer is what's going to happen when you leave the job. To be sure, termination clauses are often the most-negotiated elements of employment contracts. They can also be deal busters.
Consider a recent situation that pitted a highly sought-after CEO against a hard-nosed chairman of a real estate development firm. They had a hand-shake agreement for the CEO to leave his current job and join the developer. The coveted executive was regarded as the number-one candidate in the entire region, and potentially a key driver of the company's future success.
The chairman, who prided himself on being a savvy negotiator, told lawyers to include a harsh termination clause in the employment contract that was being drawn up for the new CEO. By the chairman's lights, the clause would serve as a bargaining chip he could use to whittle down his original lucrative offer. Among other things, the chairman had promised the future CEO a huge supplemental retirement benefit because he was leaving a lot of money on the table at his existing job.
The lawyers balked at the idea as risky and unnecessary, but they eventually acquiesced to the boss's demand. As a result, the contract included under just causes for termination vague "failed to meet board of directors' standards."
After receiving the contract, the CEO candidate refused to return the chairman's calls and killed the deal, says J. Mark Poerio, an employment practice partner at Paul, Hastings, Janofsky & Walker, who recounted the story. The CEO considered the overly aggressive clause a show of "bad faith" by his potential future boss. "It is fine to want to protect corporate interests, but not to the point of sending signals of mistrust," opines Poerio.
While termination clauses can raise hackles on both sides of the negotiating table, other contract provisions are less controversial, but still important to review. Indeed, executives employment contracts, which typically run 10 to 20 pages, are packed not only with standard compensation and termination provisions, but also plentiful nuances that a candidate should understand before signing on the dotted line.
Perhaps even more important, experts say, candidates that are negotiating contracts will feel the effects of the new Securities and Exchange Commission rule that requires public companies to disclose, in detail, the compensation packages of top executives. Employment contracts are receiving "a lot more scrutiny" from investor and other stakeholders, says Harry Graham, managing director at Smart Business Advisory and Consulting, a compensation and benefits outfit. "Everything is the proxy statement in black and white."
How Long, How Much
The agreement usually starts off with the contract period, generally a set number of years in the range of one to five, followed by a clause about automatic extensions with the caveat, "unless the board decides otherwise before the renewal date." Before settling on a term, candidates should check industry data to see what peer companies are offering. This is also an area that some new hires overlook, opines Maria Hallas, an employment attorney with Greenberg Traurig. It may be a year-long contract on its, she explains, but if it includes a provision that says the executive can be fired with 15 days notice and a month's pay, "that's really a month-long contract that is renegotiated year-to-year."
Salary is also a fairly straightforward item, and in fact is considered "the easy part," says Graham. Nonetheless, candidates should benchmark salary and compensation packages against peer-company data to develop a sense of whether they are being underpaid or overpaid.
Compensation language starts with the base salary, and should end with a clause that says something about how the amount is subject to annual increases — companies will want that increase to be at the board's discretion, and candidates should argue for as much detail as possible, says Poerio. For example, negotiate a written commitment from the board that it will develop a compensation formula by a specific date for doling out cash bonuses, stock option grants, and restricted stock. In addition, the provision should include details about performance goals and targets linked to the formula.
Another tip: make sure any stock option provision goes beyond just noting the grant date and number of shares that a candidate has the option to purchase. Incoming executives should ask for terms related to options vesting and expiration, cashless exercise, and net settlement.
It is not uncommon at the CFO level to receive restricted stock as a signing bonus. From the corporate perspective, it's a better retention device than cash, says Graham. He also points out that stock options and restricted stock are still both popular forms of executive compensation, but candidates will see some changes regarding each.
Increasingly, both types of awards have vesting schedules tied to performance rather than time, as more institutional investors are demanding that boards include pay-for-performance criteria in employment contracts. That is especially true for restricted stock, which must be booked at its fair market value and could turn out to be a drag on earnings if a company is struggling financially. When stock awards appear in contracts, however, candidates should insist that vesting periods and a net settlement clauses be included.
Companies usually are keen to insert clawback protection into contracts. These generally state that the executive will forfeit all or some of the stock awards and any proceeds or shares received through vesting or exercise if the employee violates company loyalty pacts or is involved in fraud or misconduct — usually related to financial restatement.
What a candidate should remember about clawbacks is that you may be damned if you ask about them and damned if you don't, says Poerio. Clawbacks aren't always part of the main contract agreement, but rather part of a separate stock policy agreement. Asking about them during negotiations may prompt a company that doesn't include them in contracts to investigate and add the provision. But not knowing what the policy is before signing the contract is not advisable either. The best way to handle the situation is to ask for a sample stock agreement before joining the company, says Poerio. In that way, you can negotiate from a position of knowledge.
Compared to salary clauses, termination clauses contain much more nuance. The company typically inserts language about termination with just cause — what the grounds are and what happens if there is a just-cause firing. Usually, compensation and benefit accruals cease immediately, and stock awards and unvested benefits are forfeited.
Just cause usually means serious infractions, such as an indictment or conviction on a felony involving fraud. It also can refer to any material harm done to the company or investors arising from inappropriate use of company funds or property, general misconduct that soils the company's image, intentional malfeasance, gross neglect, and impaired judgment caused by alcohol or drug abuse. Further, most executive employment contracts include a statement warning that any breach of material provisions of the contract itself constitutes just cause.
In general, the executive wants the "cause" for termination to be "as heightened and narrow as possible," advises Hallas. The description should be minimal to the extent that it avoids ambiguous definitions, such as moral turpitude, discredit to the organization, or deficient performance. Instead, get specific. A contract could note, for example, that a CFO must meet the financial goals established at the beginning of the year, which will be measured by tracking account receivables and payables, merger deals, clean audits, or other quantifiable objectives.
Pay As You Go
Leaving empty-handed is no way to leave an executive position. Executive contracts should contain some language guaranteeing that compensation and benefits will be paid through the agreement's expiration date if the CFO dies, becomes disabled, is dismissed without a just cause, or resigns for "a good reason" — which can include a demotion, an office relocation farther than 50 miles from the current address, or a cut in salary. Further, incoming executives should argue for accelerated vesting on stock awards, although the company may need to be nudged on that issue.
Severance payouts vary, but usually range between one and three times the current year's compensation, depending on company policy. Sometimes, to avoid basing the payment on a year that included a big bonus, companies insist on a two-year look-back period and take an average.
Change-of-control is another event that falls under the "good reason" to resign category. The change can relate to a merger or acquisition, a significant change in board members, or an investor buying up an unusually large stake. In any case, clauses dealing with such change should be clearly spelled out.
Also consider that a private company likely will demand that its executives surrender ownership shares regardless of the reason for departing. So candidates should negotiate for language that states if they have to surrender shares, the termination payout will be based on the fair market value of the stock. This is also the place to indicate how the shares will be appraised — by a third party, for example — and whether the payout will be provided in a lump sum or installments.
It is also crucial to review non-compete agreements before accepting a position. These are loyalty pacts that keep departing executives from working for competitors or similar industries for a period of time. Many times, non-compete agreements are not enforceable, says Poerio, but candidates should not point that out to the employer. "Keep that card in your hand in case you have to play it later," counsels the attorney.
Hallas points out that non-compete laws vary by state and that they are banned in California. They can range from six months to two years depending on the industry, and they usually specify that the departing executive cannot solicit the company's customers, raid the staff (even if the staff member approaches the former executive), make disparaging remarks about the company, or disclose critical information.
Should You Be Perky?
Perks are part of every executive employment contract, but they can "be a lightening rod for criticism," says Poerio. Now that perks must be disclosed under the new SEC rules, investors typically judge them more harshly than a large salary, even though the value is insubstantial by comparison. "My tendency is to forget the perks, and make it up in salary," posits Poerio.
He reckons that if the executive needs security protection, that's easy to explain to investors. But a compensation package that includes a Mercedes-Benz and a country club membership is harder for the public to swallow than a $100,000 bump in salary from the previous year.
For private companies, load up on perks if the investors and board are comfortable with them, Poerio continues. They still have to be "critical and justifiable," but that definition usually encompasses reimbursement for moving expenses, country club or other club memberships, company cars and drivers, life insurance, and reimbursement for legal expenses.
New hires should also keep an eye out for clauses that relate to claims release. "It is a critical company protection," maintains Poerio, who says that if it is not included in the contract, "don't mention it." A claims release provision promises candidates a set payout — usually a multiple of salary — if they agree not to sue the company for firing them without cause. Companies often attach claims releases to the contract, and stipulate that if the law changes, it has the right to rework the agreement. "Say no," insists Poerio. The deal at the time you sign the employment contract should remain in place until the contract expires.
The New York Stock Exchange gave Richard Grasso a $139.5 million severance package, Disney gave Michael Ovitz $140 million, and Home Depot paid out $210 million to Robert Nardelli. "People remember the numbers," asserts Poerio, who says the market and investors are very sensitive to lucrative severance packages, known as golden parachutes.
The only reason packages were disclosed was because the severance clauses were triggered and these top executives received their payouts. Now, however, the SEC requires disclosure of pay packages for the top brass at public companies, and that's likely to affect the negotiating position of executives, who won't be able to ink big golden parachute deals in private, contends Poerio. Boards are probably going to benchmark severance deals to market based on peer company review, he adds.
A smattering of executives also may be treated to what's known as a 280G tax gross-up provision, although this perk is falling out of favor because, again, the new SEC rule exposes it. A gross-up relates to the tax code's rule that allows companies to pay an executive additional compensation to cover the excise tax imposed on "excessive" golden parachute payouts, says Graham. The IRS determined in 1984 that departure bonus packages that exceeded three times the executive's annual average compensation for the last five years was "excessive" and therefore imposed an excise tax on the extra amount. The perk is popular because the tax can be brutal. The rule of thumb regarding the excise tax is that when combined with the regular income taxes, it can reach 50 percent, according to Graham.
Many companies also offer severance payments through "rabbi trusts," which protect a former executive from losing deferred compensation in case the company becomes financially distressed or there is a problem that delays payment. For instance, trust payments could be triggered when a company buys a target and immediately fires all the executives and does not allow them to collect severance. Or payment would flow out of the trust if executives are laid off, and then revenues dip precipitously before they are paid their severance. The company funds the trust with enough assets to pay the severance and deferred benefits outlined in the agreement. The assets stay on the company's books and appear in its financial statements, but remain beyond the control of the company.
Even when the perfect candidate walks through the door, there are a few things related to contract negotiations that really hurt his chances of landing the job. "Companies don't like executives to bring attorneys [on site] to negotiate. It's a little disarming," says Hallas. Further, potential hires have to learn to pick their battles. Bickering over tiny issues — such as a $5,000 cut in the salary offer on a $500,000 salary — is not worth angering people you will soon be working with or appearing greedy. "Let it go," Hallas advises.