Legal Considerations When Drafting Executive Compensation Agreements

Executive compensation agreements are critical for attracting and retaining top talent in any organization. These agreements outline the financial and non-financial rewards and benefits offered to a company’s senior leadership in return for their work and impact. As legal counsel for executives, it is essential to understand the intricacies of these agreements to ensure that your clients receive fair and competitive compensation packages.

This article delves into the legal considerations when drafting executive compensation agreements, covering both basic and advanced concepts to help you draft and negotiate effective compensation plans and packages for executives in C-suite positions.

Financial considerations form the cornerstone of any executive compensation package. These include:

• Base Salary: This is the fixed annual compensation paid to an executive, typically constituting a smaller portion of the total compensation package. When determining the base salary, factors such as industry benchmarks, the company’s financial health, the executive’s expertise, and the scope of their responsibilities should be considered.
• Performance Bonuses: Also known as short-term incentive plans (STIPs), these are merit-based rewards linked to specific targets or Key Performance Indicators (KPIs), typically assessed over a one-year period. These bonuses can be tied to various metrics, such as revenue growth, profit margins, or market share. To comply with Section 409A of the Internal Revenue Code, it’s important to understand the short-term deferral window, which applies if the bonus is paid later than the 15th day of the third month following the year in which it was earned4. When designing bonus plans, it’s crucial to establish clear and quantifiable performance metrics, align bonus targets with company objectives, and set appropriate payout thresholds and ceilings. It’s also important to note that short-term incentives can include various forms of rewards, not just cash bonuses. These can include additional time off or stock options, providing flexibility and aligning with the executive’s individual needs and preferences. For publicly traded companies, annual incentive plans are often subject to shareholder approval and may require re-approval every five years, unless they are formula-based. The Compensation Committee plays a crucial role in certifying the amounts paid and the goals achieved, typically documented in the proxy statement under the compensation discussion and analysis report. When designing these plans, it’s essential to consider the minimum and maximum thresholds of performance and the frequency with which executives should be achieving these thresholds. Incorporating negative discretion in the plan can allow the Compensation Committee to decrease payment after the approved plan is set, providing flexibility in adjusting compensation based on specific circumstances.
• Long-Term Incentives (LTIPs): LTIPs are designed to reward sustained performance and align executive interests with long-term shareholder value. These awards are often given in the form of equity-based compensation, which can be categorized into different vehicles:

Vehicle Type	Characteristics	Advantages	Disadvantages
Appreciation Vehicle (e.g., stock options)	Provide the right to purchase shares at a predetermined price.	Alignment with shareholders, easy to communicate, leverage, fixed expense.	May lose value if stock price declines.
Time-Vested Full Value Vehicles (e.g., restricted stock units)	Grant shares upon meeting conditions like tenure or performance milestones.	Strong retention value, alignment with shareholders, less dilutive, easy to communicate, fixed expense.	May not incentivize performance as strongly as other vehicles.
Performance-Vested Vehicles (e.g., performance shares)	Award shares based on achieving specific performance goals.	Strong focus on performance, alignment with shareholders, fixed expense (may be subject to reversal if goals are not met), may be less dilutive.	More complex to design and administer.

It’s crucial to understand the nuances of different equity types, such as Incentive Stock Options (ISOs), Non-qualified Stock Options (NSOs), Restricted Stock Awards (RSAs), and Restricted Stock Units (RSUs). Each type has its own rules regarding execution, vesting periods, and tax implications. Executives should seek guidance from specialized tax accountants who understand equity compensation to optimize their financial planning. Other forms of equity-based compensation include phantom stock, which simulates stock ownership without granting actual shares, and stock appreciation rights, which grant the right to receive the appreciation in value of a certain number of shares. In partnerships, profits interests and capital interests can be used to provide executives with a share of the firm’s profits or capital appreciation. When considering equity compensation, it’s crucial to evaluate the impact on existing owners and address potential dilution concerns. Carefully assess whether offering equity to executives would negatively affect current shareholders and explore strategies to mitigate any potential dilution.

• Deferred Compensation: This allows executives to postpone receiving a portion of their income until a later date, often with the company matching contributions. This can be a valuable tool for tax planning and retirement savings. However, it’s important to understand the tax implications of different distribution periods. For example, selecting a distribution period of less than 10 years may result in the income being taxed in the state where it was earned, while payments made over 10 years or more are typically taxed in the state of domicile. Executives should also be aware of the potential risks associated with deferred compensation, such as the company’s financial distress potentially affecting the deferred funds or incurring penalties for early access to the money. When drafting deferred compensation plans, it’s crucial to address Section 409A of the Internal Revenue Code, which imposes requirements on nonqualified deferred compensation plans. To comply with Section 409A, the plan must specify the time and form of payment and adhere to specific rules regarding permissible payment events and deferral limitations.

In addition to the above, executives should consider utilizing health savings accounts (HSAs) as a tax-advantaged way to save for future health expenses. HSAs allow pre-tax contributions to be invested and used for qualified medical expenses, providing both tax benefits and the potential for long-term growth. It’s also crucial for executives to diversify their investment portfolios to mitigate the risk of concentrated wealth. When a significant portion of their compensation is tied to the company’s performance, relying heavily on company stock and options can create concentrated wealth and increase risk. Executives should explore investment strategies to allocate investments into other assets less correlated with the company and industry.

Salary and cash bonuses, while often a smaller component of the total compensation package, provide predictability and form the foundation of an executive’s compensation arrangement. Executives should utilize these predictable income streams strategically to build cash reserves, pay off debt, fund education expenses, or contribute to other financial goals.

While financial rewards are essential, non-financial considerations also play a significant role in attracting and retaining top executives. These include:

• Benefits: Executives often receive a comprehensive benefits package that may include health insurance, retirement plans, life insurance, and disability insurance. Supplemental executive retirement plans (SERPs) and deferred compensation plans can provide additional retirement benefits. It’s also important to review insurance options, such as life insurance, disability insurance, and liability coverage, to ensure adequate protection for the executive and their family. Assessing risks and current coverage can help determine whether company insurance plans are sufficient or if a customized solution is required.
• Perks: These are non-cash rewards that can enhance the overall compensation package and contribute to the executive’s job satisfaction. Examples include company cars, club memberships, and executive health and wellness programs. In addition to these traditional perks, executives can also negotiate for flexible working arrangements, such as remote work options or flexible hours, to enhance work-life balance.
• Confidentiality and Non-Disclosure Agreements: These agreements are crucial for protecting sensitive business information, trade secrets, and intellectual property. They ensure that executives maintain confidentiality during and after their employment, safeguarding the company’s competitive advantage.
• Non-Compete and Non-Solicitation Agreements: These agreements restrict executives from working for a direct competitor or soliciting clients or employees from the company for a specified period after leaving the organization. They help protect the company’s interests and prevent unfair competition. However, it’s important to note that non-compete agreements are subject to varying enforceability standards across states. In New York, for example, the enforceability of non-competes is subject to specific requirements and limitations. The FTC has also proposed a rule to ban non-competes, which could significantly impact their use and enforceability.
• Severance Packages: These provide financial protection to executives in the event of termination. They often include continued salary payments, bonuses, and benefits for a specified period. When drafting severance packages, it’s crucial to clearly define what constitutes “good reason” for an executive to resign and receive severance4. This should include actions taken by the employer that result in a material negative change to the executive’s role, duties, or compensation. It’s also important to address the issue of termination for “cause” and the potential for including a “cure period” in the agreement, allowing the executive to address the issue before termination. Additionally, consider the possibility of retroactive termination for “cause” even after the executive has left the company and how this can affect severance payments14. To comply with Section 409A, severance agreements should address the IRS-approved approaches for eliminating executive discretion in receiving payments. This can be achieved by specifying payment on the 60th or 90th day following termination or ensuring payment in the second year if the period spans two calendar years. It’s also important to understand the interplay between severance terms and termination terms in the employment agreement, as these two aspects are closely linked and should be carefully considered together.

Drafting and negotiating executive compensation agreements can present several challenges:

• Legal and Regulatory Hurdles: Executive compensation is subject to various laws and regulations, including tax laws, securities laws, and accounting rules. It’s crucial to stay informed about these regulations and ensure compliance.
• Tax Implications: Different forms of compensation have varying tax implications for both the executive and the employer. Careful planning is necessary to minimize tax liabilities.
• Corporate Governance Issues: Executive compensation can raise corporate governance concerns, particularly regarding transparency and accountability. For example, in public companies, “say-on-pay” votes allow shareholders to express their views on the compensation of the most highly compensated executives. This highlights the importance of considering shareholder perspectives and ensuring that executive pay aligns with company performance and shareholder interests.
• Balancing Shareholder Interests: Balancing the interests of executives with those of shareholders can be challenging. Executives often seek competitive salaries and benefits, while shareholders may prioritize cost management and long-term value creation. Finding the right balance is crucial for attracting and retaining top talent while ensuring responsible corporate governance.
• Performance Measurement: Identifying and implementing appropriate performance metrics that accurately reflect an executive’s contribution can be complex. Using a single metric, such as stock price, may incentivize short-term thinking or risky behavior. Companies must develop a balanced scorecard of metrics that captures both financial and non-financial performance indicators, such as revenue growth, profitability, and strategic goals.
• Talent Retention in a Competitive Market: Attracting and retaining top executive talent in a competitive market is an ongoing challenge. Companies must offer competitive compensation packages that meet the expectations of high-performing executives while managing costs and ensuring alignment with company goals.
• Addressing Pay Equity Concerns: With increasing focus on diversity and inclusion, companies are facing pressure to ensure pay equity across gender, racial, and other demographic lines at the executive level. This requires careful analysis of compensation data, addressing unconscious biases in pay decisions, and potentially implementing corrective measures to close any identified gaps.
• Challenges and Uncertainties with Non-Compete Agreements: The evolving legal landscape surrounding non-compete agreements, particularly in New York, presents challenges for both employers and executives. The FTC’s proposed rule to ban non-competes and the uncertainty surrounding its implementation create complexities in drafting and negotiating these agreements.
• Balancing Attractiveness with Affordability: For emerging growth companies, there is a tension between attracting top talent with competitive compensation and managing costs and equity dilution. This requires a careful balancing act to ensure sustainable growth while offering attractive packages to executives.
• Shift towards Long-Term Performance-Based Compensation: There is a growing trend towards long-term performance-based compensation, driven by factors such as increased shareholder activism and the focus on long-term value creation. This shift requires companies to design compensation plans that incentivize executives to prioritize sustainable growth and shareholder interests.

When representing executives in compensation negotiations, consider the following strategies:

• Pre-Negotiation Steps: Before entering into negotiations, it’s essential to take certain pre-negotiation steps. This includes identifying the appropriate parties involved in the negotiation, such as the Board of Directors, Compensation Committee, or legal counsel. Using term sheets to outline the business deal and tally sheets to help the Board make informed decisions can also be beneficial.
• Clearly Define Your Client’s Needs: Understand your client’s priorities and goals for their compensation package. This includes not only their desired salary and benefits but also their preferences for work-life balance, career development opportunities, and long-term financial security.
• Thorough Research: Conduct thorough research on industry benchmarks, comparable compensation packages, and the company’s financial health. This information will provide valuable leverage during negotiations and help ensure that your client receives a fair and competitive offer.
• Quantify Value: Clearly articulate the executive’s value and contributions to the company, using specific examples and quantifiable achievements. Demonstrating the executive’s impact on the company’s success can strengthen their negotiating position and justify their compensation expectations.
• Strategic Negotiation: Be prepared to negotiate various aspects of the compensation package, including base salary, bonuses, equity, benefits, and severance. Consider the trade-offs between different components and be willing to compromise on certain aspects to achieve the most favorable overall package. If the initial base salary offer is lower than expected, consider negotiating a salary review within a specific timeframe. Explore the potential for negotiating the conditions around how bonuses are paid, such as the KPIs, performance measurement, or whether bonuses are paid in full or deferred over multiple years11.
• Negotiate Protections and Flexibility: Negotiate protections for unvested equity in case of termination, such as accelerated vesting or extended timeframes for exercising options. Explore the potential for negotiating shorter notice periods or enhanced severance pay in case of termination. Consider negotiating clauses that entitle the executive to severance if they resign for legitimate reasons, such as a significant change in responsibilities or a breach of contract by the company. Also, address the potential for negotiating clauses about unjust termination for executives, as they may not be protected from unfair dismissal in the same way as other employees.
• Non-Compete Considerations: Given the challenges and uncertainties surrounding non-compete agreements, consider negotiating looser “non-compete” clauses to increase the executive’s chances of finding a new role quickly after leaving the company11. Explore the possibility of negotiating alternative restrictive covenants, such as non-disclosure agreements or customer non-solicitation clauses, as alternatives to non-competes. If non-competes are limited or unenforceable, consider negotiating longer vesting periods for equity or performance-based bonuses as part of the compensation package13. Also, explore the possibility of including severance-linked provisions, tying non-compete obligations to enhanced severance packages.
• Document Everything: Ensure that all agreements are documented clearly and accurately to avoid future disputes. This includes not only the formal employment agreement but also any side letters, emails, or other communications that clarify the terms of the compensation package.
• Maintain Enthusiasm and Seek Legal Advice: Throughout the negotiation process, maintain enthusiasm for joining the company, even when negotiating tough issues. This demonstrates professionalism and commitment to the opportunity. Seek legal advice to define conditions to be included in the agreement and to review the final contract before signing. An experienced attorney can provide valuable guidance and ensure that your client’s interests are protected.

Drafting and negotiating executive compensation agreements requires a deep understanding of legal considerations, financial implications, and best practices. By carefully considering the factors discussed in this article and employing effective negotiation strategies, you can help your clients secure compensation packages that reflect their value and contribute to their long-term success. A holistic approach to executive compensation, considering both financial and non-financial factors, is crucial. Skilled legal counsel is essential to navigate the complexities of these agreements, ensuring compliance with regulations, minimizing tax liabilities, and protecting the executive’s interests.

As the legal landscape surrounding executive compensation continues to evolve, ongoing education and adaptability are crucial for both executives and legal counsel to stay informed and adjust their negotiation strategies accordingly.

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