3. Employee Terms

Term sheets usually also have a set of provisions with respect:

  • Pool of reserved shares
  • Vesting of founders' shares
  • Key person insurance
  • Non-compete clauses
  • Confidentiality, proprietary information, and invention agreement

 

The basic idea of these terms is to find the right balance between "Carrots and Sticks:"

  • Incentivize employees for taking risks, working hard, and accepting low salaries
  • Provide high-powered incentives for superior performance
  • Retain knowledge and talent in the company.

 

Pool of Reserved Shares ("Carrot")

The term sheet often sets aside a certain number of shares that can be given to employees for incentives and compensation ("Reserved Shares"). These shares typically account for 10-15% of the firm's fully diluted capitalization.

We have already encountered such a pool of reserved shares in our initial examples on the offering terms, where the firm had 5 million shares of common stock outstanding and the term sheet would stipulate to reserve an additional 3 million shares for issuance under the stock option plan.

By including a clearly defined pool of reserved shares in the term sheet, investors can avoid dilution of their ownership stake from future increases in the number of shares to compensate employees. In fact, the term sheet then generally defines that any further increases in the number of reserved shares requires the approval of the preferred stockholders (class vote) and will be treated as a dilutive event and trigger the anti-dilution provisions.

A typical formulation for the Reserved shares is:

 
Reserved Shares:
 

Upon closing of the Offering, the Company will have reserved for issuance under its stock option plan an aggregate of [X] shares of Common (the “Reserved Shares”), of which [Y] shares are subject to granted options. The Company shall not increase the number of Reserved Shares under the Incentive Plan or any similar stock option plan without the consent of the holders of a majority of the then outstanding Series A Preferred shares. Unless subsequently agreed to the contrary by the holders of [Z] of the shares of outstanding Series A Preferred, any issuance of shares in excess of the Reserved Shares will be a dilutive event requiring the issuance of additional shares of Common as provided above in “Antidilution Provisions” and will be subject to the Investors’ preemptive rights. 

 

Vesting of Founders' Shares (Stick)

The shares that the founders and employees hold are then generally subject to transfer restrictions. The term sheet defines how the reserved shares (or options) that are granted to the founders and employees become exercisable over time (so-called vesting).

  • Shares typically vest over a period of 36 to 48 months. This means that the granted shares do not become fully exercisable until 3 to 4 years after the granting date. 
  • The vesting period often starts with a so-called "Cliff" of a certain number of months, during which no shares vest. After the cliff, the shares then vest linearly.
  • For example, a term sheet could define a 48-months vesting period with a 12 months cliff and linear vesting thereafter. The implications of such a vesting arrangement are:
    • During the first 12 months after any stock grant, there is no vesting (no shares become exercisable).
    • Over the following 36 months (months 13 to 48), 2.78% [=1/36] of the granted shares then vest each month.
    • The following figure illustrates the cumulative fraction of vested shares over time implied by these deal terms. As can be seen, it will take 30 months after the grant date for half of the granted shares to vest.
       

vesting of shares  

The purpose of these vesting terms is to tie the founders and key employees to the company and give them a strong incentive to maximize the stock price. The vesting terms are often also referred to as "Golden Handcuffs," because unvested shares can generally be repurchased at cost in the event of employment termination!

In the above example, this would imply that the employee factually loses 50% of the granted shares if his employment is terminated 30 months after the grant date.

A typical vesting formulation in the term sheet is:

  

Vesting of Founders' and Reserved Shares:
 
Vesting of The Reserved Shares will have 48-month vesting with a 12 month cliff and linear monthly vesting thereafter. Founder’s shares vest 25% on closing, with remainder vesting linearly over a 36 month period, and unvested portion subject to buyback provisions. The Company has the right to repurchase unvested shares at cost in the event of employment termination. By closing the founders will have executed an employment agreement mutually agreeable to the founders and the investors. 

 

Key Person Insurance

At early stages, the fate of the company is often directly dependent on and unseparable from the fate of one or two key individuals (the founders). If something happens to these individuals, the fate of the company is often sealed. 

To prepare for the worst, and to avoid complete loss, investors will therefore typically ask for a life insurance on the key individuals, with the company as the beneficiary:

 

Key Person Insurance:
 

The Company is to obtain key person life insurance policy on [X and Y], in the amount of [Z] each, with Company as beneficiary. 

  

Other Employment Terms

The other employment terms mentioned at the beginning of this section are then relatively standard also for other employment relations (e.g., for employment at large established firms).

 

  • Non-compete clauses:
    • Try to make sure that key employees do not leave to work for a competitor or start a competitive firm.
    • Time period is usually 1-2 years with geographic restriction.
    • The enforceability of these clauses is not clear and differs between States (and countries). For example, many states would not enforce out-of-state non-compete clauses.
       
  • Confidentiality, proprietary information, and invention agreements:
    • These agreements create a confidential relationship between the parties of the deal. Without such arrangements, collaboration between entrepreneurs and investors would be almost impossible.
    • They also make sure that all relevant work product belongs to the company, and not the founder or employee. After all, the investors are shareholders of the company, not of the founders and employees.