Life Insurance Agencies and the Key Person Problem

Other terms to consider are what happens to unvested equity if the company is sold?  Does the employee forfeit all of their equity if they are a “bad actor” and are terminated for cause, or breach a non-compete or other restrictive covenant?

Key Person Life Insurance

Another common strategy is to require the company to purchase key person life insurance policies on key employees. This is most often used in very early-stage companies, where one or two people are so critical to the company’s success that it would damage the company if they were no longer a part of it.

Obviously, life insurance will not prevent a covered loss, but it may be helpful in the worst-case scenario, to enable the company to survive while it learns how to cope with the loss of a key person.

Generally, key person life insurance is most important when companies are still small and have not fully developed and documented their internal processes. Once companies achieve a certain level of scale with a complete management team, no one person becomes so crucial to success as to necessitate this approach.

Restrictive Covenants

Restrictive covenants are obligations on the part of an individual to not take certain actions that are harmful to the company. Non-competes are the most common example; these are clauses that limit a person’s ability to go work for a competing business. Other examples include non-solicitation clauses, which limit someone’s ability to induce employees, customers, or other key relationships to leave or reduce their business with the company, and non-disparagement clauses, which limit someone’s ability to speak negatively about the company.

In most states, restrictive covenants are enforceable if they are reasonable in terms of their scope of prohibited actions, their geographic scope, and their time period. While these types of covenants cannot ever force someone to remain employed by a company, they can certainly create a disincentive for them to leave voluntarily in circumstances that would be harmful to the company. Accordingly, many investors will require that the company have these in place with key employees (or, if the company is small enough, all employees).

Transaction Bonuses

For companies that are approaching the stage at which they may be looking to sell to another company, sometimes key employees will have transaction bonuses that are incorporated into their employment agreement. These are usually cash bonuses that are tied to the closing of a sale transaction and may also vary in size based on the size of the transaction. For companies that are within a few years of a possible sale, this can be an effective mechanism to retain key employees, because those bonuses are usually structured such that they are only payable if the employee remains employed as of the date of closing.

These are just a few of the more common tools available to investors to protect against unexpected key departures. Each of these is designed to either incentivize a person to stay with the company, to provide protections for the company if they do leave the company, or both.

All agency owners involved in strategic transactions, and all investors interested in participating in those transactions, would be well-served to consider these issues.

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Chris Sloan, shareholder at Baker Donelson, is chair of the firm’s emerging companies group. In addition to working with startups and other emerging businesses, he handles legal issues involving software and information technology. He can be reached at [email protected].