Clawback: Everything You Need to Know
A clawback gives investors of a new company a chance to reclaim money or stock options already given to a partner or employee. 6 min read
What Is a Clawback Clause?
A clawback clause gives investors of a brand-new company a chance to reclaim money or stock options already given to a partner or employee. Clawback clauses may also be found in the limited partnership agreements of private equity or venture capital funds.
If general partners or employees of a startup have signed a contract that includes a clawback clause, they could be forced to pay back some of their salary, benefits, and options in certain situations. This type of clause can protect limited partners or investors, letting them take back payments and equity if an employee or partner doesn't meet contractual obligations.
Why Is a Clawback Clause Important for Employees?
A clawback clause can have a huge impact on employees in a startup. Shareholders and investors must find capable technical and non-technical people to work for them. This can be difficult because working for a brand new company has some drawbacks:
- Crazy work schedules and demands, especially early on
- A lower salary or less steady paycheck
- Risk that the company will fail
Startups can offset these negatives with the promise of a payoff later. For instance, startup employees may receive equity, stock options, or other benefits to make up for lower salaries. These benefits will be outlined in the clawback clause.
If you sign a contract with a clawback clause, companies and investors can seek a vested equity if you quit or if they fire you for due cause. This encourages employees to stick with the startup instead of leaving as soon as a better offer comes along.
In European countries, clawback clauses are fairly typical, especially in startups. They are often known as a good leaver/bad leaver clause, which determines the employee's rights based on their reasons for leaving the company.
"Good" leavers stop working due to one of the following:
- Unfair dismissal
They receive their stock options and any benefits listed in the clawback clause.
"Bad" leavers include those who:
- Breach their contract
- Experience legal termination
- Quit of own accord
These leavers do not receive the full amount listed in the clawback clause.
Before signing a contract with a clawback clause, employees should make sure there is a good leaver/bad leaver clause. That way, although you risk losing some benefits if you leave of your own free will, you get to keep your perks if the company decides it doesn't need you anymore.
Investors also have clawbacks. There are times when venture capitalists can take millions of dollars in interest income before their fund has repaid initial investors. Before the investors can do that, they must agree to a clawback. This gives money back if the rest of the portfolio fails or the gains are non-existent. Similarly, some public company executives must give back their bonuses if they have participated in fraud.
Why Is a Clawback Clause Important for Businesses and Investors?
Startup companies may offer a signing bonus to attract employees. However, since they want employees who will stick with them for the long-haul, they may include a clawback clause. Then if an employee leaves early or otherwise breaks the contract, the company can get some of its money back.
On occasion, after only a year or two with a startup, employees are tempted to move on to the next opportunity and cash out. This would cut into the company's profits. Clawback clauses help protect a company's financial investment in employees. Investors may also use clawbacks in a startup to put pressure on the staff to perform well or to recoup money from file shareholders or company officers who do not meet specific goals.
Although not usually called a clawback, a company bankruptcy can offer a similar opportunity. The bankruptcy trustee, who works on behalf of creditors, can take back salaries, severance pays, and other expense reimbursements to cover the company's debt. These can even be reclaimed from employees who had nothing to do with the bankruptcy.
Example of a Clawback Provision for a Startup Company
A startup company hires a business manager to oversee its daily operations. The new hire signs a contract stating that if profits increase by 10 percent during a two-year period, he will receive a $50,000 bonus.
Two years pass, and financial records state that the company's profits increased 13 percent, so the business manager receives the bonus he was promised. Later the company's auditors claim those numbers are incorrect and profits only increased 9 percent. Because the business manager signed a contract with a clawback clause when he started this job, he must now pay back the $50,000 bonus — even though the mistake was due to a company error.
Reasons to Consider Not Using a Clawback Clause for Companies
What investors and board members can recover from top executives might be limited if an auditor finds that the company was intentionally fixing the numbers. Because of accounting scandals over the last few decades, lawmakers have directed securities regulators to create new rules that require companies to create their own clawback policies. However, these rules have not been finalized.
The problem is that some companies have a difficult time reclaiming the money, especially from high-level employees. According to a 2016 New York Times article, the Securities and Exchange Commission (S.E.C.) has only brought 40 cases against top executives since 2011. Of the 40, only 18 have repaid their companies, and those payments have totaled a mere $17 million. Many of these cases are still being litigated.
Fast-growing technology startup companies — especially those with nonvoting shareholders — do not benefit from clawbacks. Nonvoting shareholders have little if any rights compared to voting shareholders.
Reasons to Consider Not Using a Clawback Clause for Employees
Most lawyers will tell their clients to avoid clawback clauses for the following reasons:
- Lack of security. Promised money or stock options can be taken away after the fac, and there's nothing lawyers can do about it, especially if you have signed the contract.
- At-will employment. If you aren't part of a union, you run the risk of investors and shareholders ending your employment at any time, even as a payout approaches. Companies can push you out before an acquisition, and this move would make your stock options invalid.
- Reduced benefits. Some companies might threaten to reclaim stock options if they feel you aren't performing well or meeting the contract terms. Even if the company fire you and provides a severance package, it might not include the stock options or other payouts you were promised.
- Financial liability. If you've already hit your vesting numbers or cashed out your stock, you are on the hook for any clawbacks. The company will want its money back immediately, and you'll have to find a way to pay.
- Non-compete penalties. If you signed a non-compete agreement and then leave the company to work for a competitor, make sure you check the clawback clause. Some companies write in your contract that you cannot work for a rival for several months after leaving. If you do, you could face financial penalties.
- High risks. Since startups are unpredictable, you might not want to risk stock options and income that are based on the company's performance.
Frequently Asked Questions
- How do clawbacks in startups affect stock shares?
Sometimes a company makes a decision that will negatively impact its employees and offers to buy back their shares. A clawback provision would allow the employees to get their shares back in the event that the shares are resold at a higher price within a certain timeframe. Employees can sell their shares to anyone as long as the sale is legal and conflict with the company's interests.
- How are clawbacks worded?
Many clawback clauses include the following provisions:
- Penalties will be enforced for employee negligence, fraud, or intentional misconduct.
- The board or committee will take actions deemed necessary to remedy the misconduct.
- Such actions may include reimbursement of bonuses or incentive compensation already paid.
Contact an Attorney
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