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Special Employee Provisions in a Term Sheet

Cite this article as: Jason Mance Gordon, "Special Employee Provisions in a Term Sheet," in The Business Professor, updated April 24, 2015, last accessed April 2, 2020, https://thebusinessprofessor.com/knowledge-base/special-employee-provisions/.

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Special Employee Provisions

The parties often negotiate numerous employee-related provisions into the term sheet. These provisions serve as control mechanisms to either incentivize current management or allocate control over management to the investor. As discussed throughout, the control provisions employed by the investor seek to wrest away control of aspects of the business from individuals managing the business. Regarding the internal management of the venture, investors may want to control specific aspects of the hiring and incentivizing of managers. For example, the retention of current management (the entrepreneur and her team) may be an express condition to the funding deal.

The investor may see the entrepreneur leaving the venture as a significant risk for future success. In light of this perceived risk, following a round of equity investment, entrepreneurs generally receive additional ownership interest in the business that vests over predetermined period of time.  These provisions add certainty that the entrepreneur will continue to manage the business for an extended period. If the entrepreneur leaves early, any non-vested stock is lost and the vested stock is subject to buyback at a predetermined price.

Within the capitalization structure, the parties routinely designate a specific percentage of company shares for use as incentives or as compensation to management. To avoid dilution, investors may request that there be sufficient equity reserves to adequately compensate and incentivize employers to perform at their best. As with founders, employees incentivized with equity ownership in the business will generally vest in their equity rights over a specified period of time. Allowing stock to vest over a specified period aligns company and employee interests and provides an incentive to grow the value of the business. This provision protects investors from losing money (or rather from the employee unjustly capitalizing) when the business is sold very early. If the employees fail to perform and are fired prior to all of the stock vesting, then there is less equity that the firm has to repurchase. As an additional protection feature, any employee equity agreements will have some form of restriction on transfer or sale.

Lastly, investors may want any inventions by members of the business to be the property of the business. Many startup ventures survive and grow only through new internal inventions or innovations. Investors may depend on these breakthroughs to drive business growth and value. Investors impose strict control rights over employees and contractors to reduce the risk of losing any invention or intellectual property. This risk is most relevant where the entrepreneur is the driver of innovation within the business, but also has divergent business interests.

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