Key issues to address in employment agreements for founders in venture-backed companies
When founders enter into employment agreements with their own companies, particularly those looking to secure venture capital (VC) backing, a number of considerations arise that differ from standard employment contracts.
Founders play a unique dual role as both significant shareholders and employees. While venture capital firms prioritise governance, risk management, and ensuring that a company can scale effectively, founders must protect their interests as employees while balancing the long-term success of the company. This article outlines the key issues to address and matters to cover in an employment agreement between the founder and their company in this VC-focused context.
1. Role definition and responsibilities
Founders typically serve as CEOs, CTOs, or hold other leadership roles in the early stages of the company. An employment agreement must clearly define the founder’s role, scope of responsibilities, and reporting lines. This clarity ensures alignment between the founder and the company’s board and investors.
The agreement should:
- explicitly state the founder’s title and core responsibilities
- outline any expectations regarding growth or changes in the role over time
- include performance targets or KPIs that may be used to evaluate the founder’s contributions to the company’s progress.
As the company scales, venture capitalists (VCs) may require changes to the founder’s role, which can be tied to future executive hires. The contract should, therefore, provide a mechanism for revisiting and modifying responsibilities over time, ensuring the founder remains appropriately positioned as the company grows.
2. Compensation structure
A well-structured compensation package for founders includes salary, bonuses, equity, and potentially other incentives. Given the cash constraints of start-ups, initial salary offers for founders are often lower than industry standards. However, the employment agreement should address how the founder’s compensation might evolve as the company becomes more stable and profitable. Components to consider are listed below.
Base salary: This is typically modest in early-stage companies but should include provisions for reviews as the company raises additional capital or reaches specific revenue thresholds.
Bonuses: Performance-based bonuses can be tied to milestones such as successful funding rounds, product launches, or revenue goals.
Equity compensation: Stock options or restricted stock grants are crucial for founders, aligning their incentives with the company's growth and the interests of the investors. The agreement should specify the vesting schedule, acceleration clauses (especially in the case of a change in control), and any buy-back rights the company may have.
Statutory entitlements and obligations: It’s important to be mindful of statutory entitlements that founders are eligible to if they are employed by their own companies. Examples include annual leave and mandatory health insurance.
Also remember that there may be mandatory requirements that govern and regulate the manner in which salaries must be paid to employees (which must be complied with if a founder is employed by their own company).
Additional benefits: Retirement plans and other benefits should be outlined, even if these are minimal at the early stages. This ensures clarity and reduces the potential for disputes as the company matures.
3. Equity vesting and ownership
One of the most important aspects of a founder’s employment agreement is the treatment of equity. Since founders often receive significant equity in exchange for their work, the agreement must outline how and when equity vests, and what happens to that equity if the founder leaves the company.
Vesting schedules: A typical vesting schedule for founders in VC-backed start-ups is four years, with a one-year cliff. This means that if the founder leaves before completing one year of service, they forfeit all equity. After the cliff, they typically vest monthly over the remaining three years. This structure aligns the founder’s long-term interests with the company’s success.
Acceleration clauses: In the event of a sale or acquisition, ‘single-trigger’ or ‘double-trigger’ acceleration clauses allow founders to vest some or all of their unvested equity. Single-trigger acceleration allows immediate vesting upon a sale, while double-trigger requires both a sale and termination of employment for vesting to accelerate.
Founder repurchase rights: The agreement may also include provisions allowing the company to repurchase a founder’s shares if they leave before the vesting period is complete. It’s important to specify the price and terms under which such a repurchase would occur.
Founders play a unique dual role as both significant shareholders and employees. While venture capital firms prioritize governance, risk management, and ensuring that a company can scale effectively, founders must protect their interests as employees while balancing the long-term success of the company.
4. Termination and severance provisions
The conditions under which a founder can be terminated are essential elements of an employment agreement. VCs often insist on having clear termination provisions in place to mitigate risks to the company. Termination clauses generally include the below.
Termination without notice: This provision outlines specific circumstances under which the founder can be terminated without notice, which might include gross negligence, fraud, or a significant breach of duties. In certain jurisdictions, such events are prescribed under applicable law, and it may not be permissible for employers to deviate from these events.
Termination with notice: The agreement should specify what happens if the founder is terminated with notice. Typically, this includes some form of severance package – salary continuation, benefits, and possibly acceleration of equity vesting. Severance terms might scale depending on the length of the founder’s tenure and the company’s financial position.
Remember that in certain jurisdictions, there are minimum notice periods that must be complied with when terminating employment.
Termination by the founder: If a founder voluntarily resigns, the employment agreement should outline the terms under which they would leave, including any forfeiture of unvested equity and benefits. Clear notice periods should be agreed upon to ensure a smooth transition.
Change of control provisions: In the event of a merger or acquisition, both the founder and the VC investors will want clarity on what happens to employment and equity. The agreement may include severance or vesting acceleration triggered by a change of control.
5. Non-compete and non-solicitation clauses
VCs typically want to ensure that founders don’t leave the company to start a competing venture or recruit key employees away from the business. As a result, VC-backed start-ups often include restrictive covenants in employment agreements, such as the below.
Non-compete clauses: These provisions prevent founders from working in a competing business for a specific period after leaving the company. Founders should ensure the scope of the non-compete is reasonable in terms of geographic reach, duration, and the definition of ‘competition’.
In certain jurisdictions, while non-compete clauses are recognised, they are very narrowly interpreted and may not be readily enforceable by the courts.
Non-solicitation clauses: These provisions prevent founders from soliciting the company’s employees, clients, or customers for a set period. Again, the scope and duration should be carefully considered to avoid overly broad restrictions that could harm the founder’s future opportunities.
6. Confidentiality and IP assignment
The employment agreement must include robust confidentiality and intellectual property (IP) assignment clauses. For VCs, the protection of the company’s intellectual assets is paramount, especially in industries where patents, trade marks, or proprietary technology play a key role. Key provisions include the below.
Confidentiality obligations: Founders should be bound by a duty to protect the company’s confidential information during and after their employment. This includes proprietary business strategies, customer lists, and financial data.
As a reminder, unlawful disclosure of confidential information may give rise to criminal liability in certain jurisdiction.
IP assignment: Any intellectual property developed by the founder during their employment must be assigned to the company. This ensures that the company holds the rights to key inventions or products that may be central to its business model. The agreement should outline the scope of IP assignment, covering work done during employment and possibly even before official employment if that work is relevant to the company’s founding.
7. Board of directors and governance
For founders of VC-backed companies, governance is a major concern. VCs often require board seats and a level of oversight over the company’s strategic direction. The employment agreement may address the below.
Board seat: Whether the founder is entitled to a board seat as part of their role. It is critical for founders to negotiate this upfront, especially if they want to maintain a say in strategic decisions.
Voting rights and approvals: The agreement should clarify the founder’s voting rights on the board and any specific matters that require their approval.
Conclusion
Drafting an employment agreement for a founder in a VC-backed company involves addressing several unique issues that reflect both the founder's pivotal role and the expectations of VC investors.
From role definition and compensation to equity vesting, termination, and confidentiality, these agreements require careful negotiation to balance the founder’s personal interests with the long-term success of the company. Clear, fair terms will ultimately serve both the founder and the company by reducing potential conflicts and aligning everyone toward a shared goal of growth and profitability.