Many businesses are dealing with unprecedented market uncertainty and financial stress on the back of COVID-19, forcing some into cash conservation mode. As a startup’s business model may still be in development, these businesses, in particular, face unpredictable cash cycles (even in normal circumstances) and shortened runways, amplifying COVID-19’s impact. This impact is felt across the business, including the company’s employees. Accordingly, startup founders and executives should consider some unique issues, including:
Implications of depressed valuations on equity compensation. Startups often incentivize early employees, founders and management through equity interest—typically in the form of an option grant. This is a key recruitment tool and incentive for those individuals, particularly since the cash component of their compensation is often below market. Equity compensation packages may face significant risk on the back of potential declines in company valuations. Employers should be vigilant of the impact on employee morale and consider several options to help better align employee incentives, including top-up grants and repricing historical options (each option will have its own advantages and disadvantages, and professional advisors should be consulted before implementing any such changes).
Layoffs, terminations and leaves. In the current financing climate, many startups are hyper focused on extending their runway. As labour is often the most significant cost incurred by a startup, employers may ask employees to take time-off (paid or unpaid) or they may take steps to reduce the active workforce through reduction of hours, layoffs or terminations of employment. Both employees and employers should be mindful of the legal consequences of each of these options, and their associated risks. In addition, each scenario may have consequences to employee equity compensation, including possible forfeiture, depending on the terms of the equity incentive plan.
Workplace health and safety. Most technology startups are able to implement work-from-home (WFH) policies. However, where employees continue to report to an office location, employers have legal obligations to protect the health and safety of their teams. This obligation must be balanced with protecting integrity and privacy of the employees.
This article will explore these and other considerations relevant to startup companies, and provide guidance on navigating these issues responsibly.
Declining valuations: Is your equity compensation package at risk?
Early stage companies may not be able to compensate their employees at market rates. Accordingly, startups often grant team members equity to attract talent and achieve critical alignment between founders, employees, and investors.
Equity arrangements can take various forms but the most common is an employee stock ownership plan (ESOP). The plan text and grant agreements will lay out several factors governing the options’ mechanics. For example, the ESOP text will often say that the exercise price will be the fair market value of the underlying shares on the date of grant. The expectation is that, over time, the company’s valuation will grow and significantly exceed the applicable exercise price—allowing the employee to profit from the equity upside.
Unfortunately, some startups may experience declines in their valuations as a result of COVID-19. These lower valuations affect the intrinsic and perceived value of the options, weakening their impact as a motivational tool and incentivization mechanic, both for existing and new employees.
In response, depending on financial position, employers may voluntarily or at the request of employees consider topping-up option grants (i.e., providing additional equity in the company) to help offset declines in equity value. Alternatively, options can be repriced to align with the current, lower company valuation, however, this may have negative tax consequences. Depending on the terms of the option grant, employees may be able to delay exercising options until valuations have recovered. Options granted to new employees should have updated exercise prices to reflect the current environment. Before implementing any option related changes, a company should always consult with their professional advisors to understand the full impact of any such changes on their business, tax liabilities and capitalization table.
Founders and directors of startups should proactively work with their employees to ensure equity compensation is managed in a responsible, balanced and appropriate manner.
The basics on layoffs and termination (and equity implications)
Business disruptions and market uncertainty can force startups into cash conservation mode. Employers looking to conserve cash may seek to reduce headcount (temporarily or permanently). Canada’s employment laws provide employees certain minimum protections in these types of situations. That said, it is useful to differentiate between termination (i.e., permanent cessation of employment) and lay-offs (i.e., usually a temporary suspension of employment). These types of scenarios can also put equity compensation at risk.
Terminations: A permanent cessation of the employment relationship
Employers can typically permanently dismiss employees without cause at any time, but will need to provide notice of such termination or pay in lieu of notice, among other things, in accordance with the employee’s statutory, contractual and/or common law entitlements. Notice periods will depend, in part, on the length of time an employee has provided services to the employer, although written and enforceable employment contracts may also inform this period. Notice periods can vary greatly, and are generally determined on a case-by-case basis. That said, employers should exercise caution and refrain from terminating employees because they have exercised a right to take a statutory leave of absence, including in connection with the current health crisis.
Temporary lay-offs and reduced working hours
Employers can also generally temporarily lay-off employees, so long as employees consent to the lay-off or the employment contract allows for it. However, employment law imposes limits on the duration of permitted lay-offs. Surpassing the permitted duration creates a risk that the lay-off will be deemed a termination of employment. For example, in Ontario, lay-offs usually cannot exceed 13 weeks in any period of 20 consecutive weeks, unless the employer continues to provide certain assistance to the employee (e.g., compensation, benefits, etc). Unlike termination, temporary lay-offs will probably not impose advance notice rights or pay in lieu.
Ontario recently implemented a new statutory leave of absence called an infectious disease emergency leave. Any employee whose hours of work were reduced or eliminated on or after March 1, 2020 for reasons related to COVID-19 is deemed to be on an infectious disease emergency leave, with many of the rights and obligations afforded to other employees on a statutory leave of absence. The leave can last until six weeks after the day the emergency declaration in Ontario ends. The deemed leave does not apply to resignations or terminations that occurred prior to May 29, 2020.
What risks does this create on equity compensation?
The terms contained in the equity plans and related agreements will normally set out the treatment of outstanding grants in the event of termination or lay-off. There is a risk that these types of events may seriously impact employee equity packages.
For example, ESOPs provide for expiration of options a specified number of years following the date of grant. In addition, where an employee is terminated, unvested and even vested options may quickly expire and become un-exercisable. Employers should review the terms of their equity arrangements and determine whether there are any risks of employees forfeiting earned/vested equity.
Workplace health and safety
Canadian employers must take reasonable care to provide a safe and healthy workplace. At the same time, there are also broad privacy and human rights laws that restrict employers from performing medical examinations on their employees. That said, employers may be permitted to take certain steps if it is reasonably required to assess an employee’s ability to work.
For a more fulsome discussion of workplace health and safety in the context of COVID-19, please see our comprehensive guide on the matter.
During COVID-19, some employers have implemented mandatory temperature checks for employees coming into the workplace. This practice may be viewed as controversial but could be acceptable in some circumstances. The issue may be less relevant for startups as they may have implemented WFH policies and can continue remote work without disruption. However, employees reporting to work should be prepared for new workplace policies, including possible temperature checks. Employers who implement this practice should make sure it is as minimally invasive as possible and use best efforts to protect any personal information they collect in the process.
Testing positive for COVID-19
If an employee tests positive for the virus, employers may have obligations to disclose certain information to the workforce and other entities to mitigate transmission. However, in light of privacy laws, employers should use best efforts to not disclose the name of any specific employees. Instead, generic disclosure can be used for those employees who may have come into contact with an infected person.
To discuss these issues, please contact the author(s).
This publication is a general discussion of certain legal and related developments and should not be relied upon as legal advice. If you require legal advice, we would be pleased to discuss the issues in this publication with you, in the context of your particular circumstances.
For permission to republish this or any other publication, contact Janelle Weed.