Six Key Considerations: Executive Contract Negotiations, Straightline

Negotiating executive employment contracts is an art and can be rewarding—two parties entering into a relationship with a positive view toward the future. But the two parties must also identify and address the “downsides” and focus on the economics of a successful relationship. To that end, this article outlines six considerations that should drive every negotiation.

CONSIDERATION 1: PRE-NEGOTIATION STEPS

Determine the Proper Parties. With larger employers, the question often arises as to “who” should negotiate the contract on behalf of the employer. Should it be the Board of Directors, the Compensation Committee, an executive of the employer or in-house legal counsel? With publicly-traded employers, the answer is often found in the charters of the committees of the Board of Directors (generally the charters of the Compensation Committee and Nominating & Governance Committee, as well as governance guidelines).

Use Term Sheets and Tally Sheets. Term sheets outline the business deal and can help the parties come to an agreement on the business terms more quickly. For publicly-traded employers, “tally sheets” should also be used to help the Board of Directors make an “informed” decision before approving executive compensation, by listing each component of an executive’s compensation and total amounts.

CONSIDERATION 2: DUTIES & EXCLUSIVE SERVICES

Duties. At first glance, the definition of duties may appear boilerplate. But in reality, this section may dictate key economics, such as when or if: (1) the executive could later voluntarily terminate his or her employment for “good reason” and receive severance pay, or (2) the employer could terminate the executive’s employment for “cause.” By drafting this provision broadly, an employer typically retains more flexibility—for example, if the executive reports to a position instead of a named individual.

Exclusive Services. This section requires the executive to devote his or her full working time to the employer. If outside activities are permitted (e.g., serving on the board of directors of another company), it is good practice to identify such activities and require the employer’s consent.

CONSIDERATION 3: ELEMENTS OF COMPENSATION

Types of Compensation. Compensation has various elements, such as base salary, annual/performance bonus, signing bonus, equity grants, inducement grants, benefits, perquisites (e.g., car allowance), relocation assistance and reimbursement of legal fees the executive incurs in negotiating the executive contract. For publicly-traded employers with limited shares remaining in the share reserve of their equity incentive plan, the employer may consider making an “inducement” grant of equity outside of the shareholder-approved plan. If certain procedural rules are followed, inducement grants of equity would not require shareholder approval under applicable NYSE and NASDAQ listing rules, and could help preserve the share reserve under the equity incentive plan.

Amount of Compensation. Knowing the competitive market is key because the best compensation package falls within the window of “not too much” and “not too little.” Studies based upon industry, revenue, geography and job title can provide helpful information on market pricing. And if the employer is publicly-traded, then benchmarking against the employer’s peer group can provide more custom information on current market practice and competition for executive talent.

CONSIDERATION 4: FORM OF EQUITY AWARDS

Assuming the parties intend to incorporate equity awards as part of the compensation package, determining what form/type of equity award will depend upon whether the parties intend to structure performance incentives, share in ownership, maximize capital gains and defer income recognition, among other objectives. The goal of the parties should dictate the form of award.

CONSIDERATION 5: SEVERANCE AND EMPLOYMENT TERMINATION TRIGGERS

Termination Triggers. Most executive contracts address termination of employment by the employer under various scenarios, such as Cause. The executive may also be entitled to severance if he or she terminates employment for Good Reason, Disability, Death or other specified events. As to Cause, should the executive have the opportunity to cure the Cause condition before being terminated? And if evidence is later acquired after termination that would have supported a termination for Cause, should the employer be able to retroactively terminate the executive for Cause (thereby eliminating any future severance payments)?

Severance Pay. Ideally, severance packages should be designed as “bridge pay,” acting as a bridge between two employers; thus, the amount of severance pay should depend upon the executive’s position. Severance may be paid in a lump sum, over a period of time (allowing the employer to enforce restrictive covenants), or in payments subject to offset for any income received from the terminated executive’s new employer. Generally, a departing executive must waive all known and unknown claims against the employer as a precondition to receiving any severance pay.

CONSIDERATION 6: MINIMIZE POTENTIAL SECTION 280G IMPACT

What is the point of awarding compensation unless the executive is entitled to keep it upon a change in control? “Golden parachute” rules under Section 280G could trigger a 20% excise tax to the executive on change in control payments and a corresponding disallowed tax deduction to the employer. The negative impact associated with Section 280G is outside the scope of this article. However, one or more of eleven different Section 280G mitigation strategies may be incorporated into the executive’s contract.

CONCLUSION

By focusing negotiations on key economic terms, the employer and executive may increase the value of the arrangement to both parties, build for a stable relationship and retain executive talent into the future. For public employers, well-designed employment contracts are a visible indicator of good governance.