Betting on the jockey
Vishal Achanta February 16, 2017
“Bet on the jockey, not the horse” goes the adage; it highlights a key aspect of early-stage investing – people (read: key employees of a company), and their ideas/execution capabilities are as important as ‘product’. It follows that preserving the value brought in by ‘people’ is vital for early stage companies and investors in such companies. Keeping this in mind, this article will discuss an important piece of documentation seen in early stage deals – the key employee agreement entered into between a company and its key employees (“KEA”) – its drawbacks, and solutions used to address these drawbacks.
The important terms of a KEA are the intellectual property (“IP”) assignment, confidentiality, and non-compete/non-solicit covenants. These terms attempt to provide investors with protection against a situation where key employees leave a portfolio company, taking valuable trade secrets and client relationships with them, thereby eroding value for the investor. This can be a big risk in certain sectors where ‘people’ play an outsized role in a company’s success, or where IP is a major differentiator for the company.
Consequently, (1) in the due diligence stage of a deal, there should be a thorough analysis of existing KEAs to analyze whether they are sufficiently robust – if none are in place, KEAs should be insisted upon as a condition precedent to the deal, and (2) KEAs should be very carefully drafted to ensure adequate protection for the investor.
Two threshold commercial issues when dealing with KEAs are:
1. Who exactly is a ‘key employee’? There is no hard-and-fast rule here; the key employees of a company will vary with both sector and stage; obviously, the founder would be a ‘key employee’. A picture of who the key employees of a company actually are should emerge from the due diligence based on the investor’s understanding of the team and business model of the company.
2. Some key employees (especially the founders) may be hesitant to enter into restrictive employment agreements: founders will make the argument that they have put their equity into the venture, and are thus sufficiently aligned, and therefore should not be required to sign aggressive and restrictive KEAs; other key employees may not have an equity interest in the company and therefore will not feel aligned enough to make a big commitment to the company through such KEAs – more on this later.
Coming to the legal issues:
1. While IP assignment and confidentiality may be well-drafted and tight on paper, investors and companies would be well-advised to think through the practicalities of how to ensure that there is no leakage of data and trade secrets. Given that IP assignment and confidentiality clauses on paper are definitely not a ‘cure’ for leakage, it is best to rely on ‘prevention’ by ensuring adequate cyber security, conducting frequent checks,
and putting in place a controlled work environments etc. However, neither the KEA nor other preventive measures are fool proof.
2. The real elephant in the room is the non-compete clause: while a non-compete that extends beyond the term of a KEA is standard in India, the enforceability of such a term is in doubt due to judicial precedents. In short, if key employee ‘A’ leaves Company B and immediately joins a competitor, there is not much that Company B can do about it, even if A has entered into a KEA with Company B wherein she agrees that that she will not compete with B for 1 year after leaving Company B. While one can effectively make non-solicit and confidentiality clauses do the job of a non-compete clause, courts may not look favourably upon this tactic, and hence, drafting a KEA requires a delicate balancing act in this regard.
Having regard to the above, investors should be concerned that KEAs do not turn out to be mere paper protections. A possible solution is to ensure that there is true interest alignment between companies and their key employees, so that psychologically and commercially, the key employees understand that they are better off staying than leaving, thereby eliminating the need to rely heavily on KEAs for protection.
There are different approaches to accomplishing this, depending on whether the KEA in question is the founder or not; to a large extent, these have already been adopted by the market, and are described below:
1. Investors typically insist on portfolio companies creating an ESOP at the time of investment – an ESOP is the best tool for creating interest alignment between non-founder key employees and a company. A good (and generous) ESOP will give key employees a clear roadmap to a point in the future when they will share ownership of the fruits of their labour, and will thus incentivize key employees to stay and share upsides with the founders.
2. When it comes to founders, the best approach may be a combination of a KEA and a ‘vesting’ clause in the deal documentation. Since founders already own equity, vesting essentially ‘suspends’ their ownership of their shares for a period of time in order to (i) incentivize founders to stay with the company until their equity ‘vests’ back with them, and (ii) ensure that a founder will not ‘walk away’ with her shareholding intact even if she is fired from the company for a violation of the KEA i.e., when a founder is a ‘bad leaver’, her shares are ‘clawed back’.
Both ESOPs and vesting clauses have their own set of issues that require careful consideration. For instance, vesting clauses are not exactly ‘market’ in India, and may result in pushback from founders. ESOPs must be structured carefully to (1) ensure that investors are not diluted, & employees adequately incentivized, and (2) allow liquidity events for all involved to proceed smoothly. As always, investors should seek advice from deal counsel who are conversant with these matters to ensure that their bets on jockey and horse come good.
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