Key Takeaways

  • Equity clawback provisions allow companies or investors to reclaim previously granted equity or compensation under specific conditions.
  • These clauses are common in private equity, executive compensation, and employee stock plans, protecting against misconduct or performance failures.
  • Clawbacks are triggered by events such as financial restatements, regulatory violations, or failure to meet contractual terms.
  • For employees, equity clawback provisions can impact the security of stock options or bonuses, particularly if they leave the company or are terminated for cause.
  • While clawbacks serve as a risk management tool, they can also create uncertainty for recipients and may not be suitable in every business situation.

An equity clawback allows a bond issuer to refinance a specific percentage of outstanding bonds. The refinancing happens using proceeds from an equity offering, which is from the initial or follow-up offerings. They are contract provisions for money paid for services which are reimbursable under specific circumstances outlined in the contract. Essentially, they create a balance between economic and community development and corporate welfare.

What is a Clawback?

The term clawback means an action where a benefactor or employer takes back money that was already distributed, likely with a penalty added on. Some companies might include clawback provisions into their employee contracts, whether these provisions regardless of legal requirements. For example, these allow the employer to recover bonuses that have already been paid out.

A fund liquidation prompts clawback calculations. For example, Medicaid can “claw back” costs from the estate of a deceased patient. There are other instances where a clawback might not even be monetary. An attorney can claw back privileged documents that were accidentally submitted during electronic discovery.

Clawbacks can also be used to keep people from using false information, like the misuse of accounting information in the financial industry. Clawbacks can also be used in other circumstances as well. In private equity matters, a clawback refers to a limited partner's rights to reclaim a portion of a general partner's carried interest in matters where consequent losses mean general partners received excess compensation.

How Equity Clawback Works in Private Equity

In private equity, an equity clawback provision is designed to ensure fair distribution of profits between general partners (GPs) and limited partners (LPs) over the life of an investment fund. Typically, GPs receive a share of the profits—called "carried interest"—once certain performance hurdles are met. However, because distributions often occur before a fund is fully liquidated, early profits may need to be adjusted if later investments underperform.

An equity clawback clause allows LPs to reclaim a portion of previously distributed carried interest if, after all investments are realized, the total returns do not justify the GPs’ share. This ensures that GPs only keep their carried interest if the fund as a whole meets its promised benchmarks. Without such a provision, GPs could potentially benefit disproportionately from early gains while LPs bear the burden of later losses.

Executive Compensation and Clawbacks

The Sarbanes-Oxley Act of 2002 was the first federal statute that allowed clawbacks for executives' pay. It allows for claw back of incentive-based compensation and bonuses of CFOs and CEOs if any misconduct by the company requires them to restate their financial performance. It should be noted that it's not required that the CFO or CEO was the one who committed any wrongdoing.

Another act that allows for clawbacks of incentive-based compensation and bonuses that were paid to a company executive or the next 20 highest-paid employees is The Emergency Economic Stabilization Act of 2008. It's applicable to companies receiving TARP funds, and when there's a determination that financial records were inaccurate, no matter whether there was misconduct or not.

There is a limitation on the clawback. It is only applicable to the excess of what would've been paid under the restated financial results.

Equity Clawback in Employment Agreements

Equity clawback provisions increasingly appear in employment agreements, stock grant documents, and company stock plans. These clauses allow companies to require employees or executives to return shares, profits from the sale of shares, or incentive compensation if certain triggering events occur.

Common triggers for equity clawbacks in employment include:

  • Fraud or misconduct, such as violating company policies or legal regulations.
  • Financial restatements, especially if bonuses or stock were awarded based on misstated earnings.
  • Departure from the company under specific circumstances, such as termination for cause or violation of noncompete agreements.

If a clawback is activated, the employee must either forfeit vested shares, return already exercised stock or pay back the cash value. Clawbacks provide a legal avenue for companies to protect themselves and shareholders from executive actions that could harm the business or inflate reported performance.

Examples of Clawbacks

Clawbacks can be found in a number of areas:

  • Government contracts — Contractors can be subject to a clawback if they fail to meet certain government contract requirements
  • Life insurance — There could be a provision that dictates if a policy is canceled, payments must be returned.
  • Dividends —There are certain circumstances where dividends can be clawed back

Common Triggers for Equity Clawback Provisions

Equity clawback provisions are generally triggered by:

  • Restatement of financial results: If compensation was based on inaccurate financial statements, the company may seek to recoup excess equity or bonuses.
  • Regulatory violations: Breaches of securities laws, insider trading, or noncompliance with industry regulations can trigger a clawback.
  • Breach of contract or policy: Violating employment agreements, codes of conduct, or noncompete clauses.
  • Underperformance of investments (in private equity): When later losses reduce overall returns below thresholds justifying carried interest previously paid to GPs.

Clawbacks can apply not just to cash but also to stock options, restricted stock units (RSUs), and other equity-based awards. This helps align the interests of employees, executives, and shareholders while providing recourse for corporate wrongdoing or error.

Why are Clawback Clauses Important for Employees

Clawback clauses can have a significant impact on startup company employees. Shareholders and investors need to find skilled technical and nontechnical employees. This can be a challenge since startup companies have their share of challenges, like lower salaries, hectic work schedules, and certainly the risk that the company won't survive. To offset this, startups sometimes offer the promise of a payoff later. Employees might receive stock options, equity, or other benefits that can make up for the initially lower salaries. Any benefits like this will be outlined in a clawback clause.

In the event, you signed a contract that contains a clawback clause and you quit or get fired for due cause, the company may seek a vested equity. This is to encourage employees to stay with the startup company rather than jump ship if a better opportunity comes along.

Clawback clauses are pretty typical in European countries, especially with startups. They are more commonly known as a good leaver/bad leaver clause, which establishes an employee's rights based on his or her reasons for departing the company.

Employees who leave for certain reasons are considered good leavers:

  • Disability
  • Death
  • Unfair dismissal

On the flip side, bad leavers are ones who depart under less than desirable circumstances, and therefore do not receive the entire amount outlined in their clawback clause:

Key Benefits and Drawbacks of Equity Clawbacks

Benefits:

  • Protects investors and companies from financial harm due to misstatements, fraud, or misconduct.
  • Encourages responsible behavior among executives and employees.
  • Provides recourse for shareholders and fund investors in cases of underperformance or regulatory breaches.
  • Supports regulatory compliance and strengthens corporate governance.

Drawbacks:

  • Can reduce the perceived value and security of compensation for employees and executives.
  • May discourage risk-taking or innovation if employees fear retroactive penalties.
  • Enforcement can be complex, involving lengthy legal proceedings or negotiation.

Careful consideration and clear communication of clawback terms are critical when including them in equity or compensation agreements.

Reasons Not to Use a Clawback Clause

Many lawyers will advise clients against accepting clawback clauses for a number of reasons:

  • There is a lack of security since promised funds and options are revocable,
  • At-will employees don't have union protection so termination may occur at any time.
  • Be cautious if you signed a noncompete clause and start working for a competitor as you could be subject to financial penalties.

How to Navigate Equity Clawback Clauses

If your compensation or investment includes an equity clawback clause, it is important to:

  • Review the triggering events and circumstances under which a clawback may occur.
  • Understand your rights regarding the return of equity, bonuses, or profits.
  • Seek legal advice if the terms are unclear or seem overly broad.
  • Keep documentation of all stock grants, compensation decisions, and related agreements.
  • Be aware of how leaving your employer, whether voluntarily or involuntarily, may affect your equity holdings.

For both employers and employees, clear, well-drafted equity clawback clauses can help prevent disputes and set fair expectations. If you need help reviewing or negotiating an equity clawback, you can post your legal need on UpCounsel’s marketplace.

Frequently Asked Questions

1.  What is an equity clawback provision?

It is a contract clause allowing an employer, investor, or fund to recover previously awarded equity or compensation if certain conditions, such as misconduct or financial restatement, are met.

2. When do equity clawbacks typically apply?

They are usually triggered by financial misstatements, regulatory violations, contractual breaches, or underperformance in private equity funds.

3. Who do equity clawback clauses protect?

They protect employers, shareholders, and investors by ensuring that bonuses or equity awards are only kept if performance standards and legal obligations are met.

4. Can an employee lose already vested shares due to a clawback?

Yes, if a clawback provision applies, vested shares or the cash value from sold shares may need to be returned under certain circumstances.

5. Are equity clawback clauses legal everywhere?

While commonly used, the enforceability of clawback clauses depends on contract law and specific regulations in each jurisdiction. Legal advice is recommended for complex cases.

If you need help with an equity clawback, you can post your legal need on UpCounsel's marketplace. UpCounsel only accepts the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.