Investors usually have several criteria for making an investment, but most will tell you that the management team is the most important.
The business model and market opportunity may be terrific, but, if agency owners and managers do not believe the team can execute on it, they will not invest.
However, agency owners and managers sometimes fail to consider what happens after they make an investment. What happens after the closing when a key member of the management team leaves the company?
How a life insurance agency handles key person retention may involve state licensing and business continuity rules, federal antidiscrimination rules, and a variety of carrier, distributor and errors and omissions coverage provider contract terms.
Agency owners should make sure to talk to their compliance advisors and risk management advisors when developing their key person retention programs.
Of course, if you help clients set up key person arrangements yourself, you may already be familiar with this.
If you aren’t personally involved in this type of business planning, then you may need to think about how this applies to your own life insurance agency.
In this article, I will discuss four common ways to either protect employees from leaving, or to incentivize them to stay: equity vesting restrictions, restrictive covenants, key person life insurance policies, and future transaction bonuses.
The most commonly used strategy is to impose vesting restrictions on the equity of the management team. Simply put, each team member must “earn” their equity over time through service to the company. If they leave at any time, for any reason, including death, then any of their equity that is not vested is forfeited. This structure incentivizes key team members to stay with the company long enough to fully vest, and, in the event that a key member leaves, their unvested equity can then be re-used to hire a qualified replacement.
Vesting is usually time-based, because investors want to incentivize key employees to remain with the company. For most employees, the standard vesting structure is four years, with the first 25% vesting at the end of one year (often called the “cliff”), and the remainder vesting monthly or quarterly over the remaining three years. For founders or very early employees, sometimes shorter periods are used; longer periods are more favorable to investors. Similarly, if the key employees are already subject to a vesting agreement that does not have sufficient time remaining, investors may require that the vesting period be extended, or new equity be issued with a fresh vesting term.
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 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).
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.
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 firstname.lastname@example.org.