As part of our Founder Series, in this piece we look at the ‘Cause’ clause in founder employment agreements and shareholder’s agreements. Essentially, under employment agreements this provision outlines circumstances/ events that trigger the termination of a founder’s employment or leadership role within the company, without the obligation on the company to provide severance or other associated benefits. More often than not the ‘Cause’ clause also finds its way into shareholders’ agreements, setting in motion breach and default remedies (potentially including an accelerated exit) for investors under the shareholders’ agreement.
As a founder, expect the kitchen sink and more in the first draft of the ‘Cause’ clause. This means inclusion of all anticipated events that might in any way affect the business, integrity, operations, or reputation of the investee company. For example, an all sweeping ‘Cause’ clause will attempt to include “an act of moral turpitude” by the founder or a mere filing of a chargesheet (as opposed to a conviction) as a ‘Cause’ event, and will not account for the nature or the seriousness of the alleged offense by a founder in question: so, if a charge sheet is filed basis a mere traffic violation or basis a complaint of “public nuisance caused by littering”, your “Cause” clause might make you lose control of your company.
Here are a few suggestions for founders to consider when negotiating the ‘Cause’ clause. Firstly, where the ‘Cause’ clause includes events relating to legal offences as discussed above, these should be clarified to state that mere framing of charges will not be a ‘Cause’ event and also that such events should be limited to “serious offences”. Where the ‘Cause’ clause includes ‘a failure to meet specific targets or key performance indicators’ as an event, it is a fair ask to carve out from the definition “any failure attributable to unforeseen market conditions beyond the reasonable control, including but not limited to, economic downturns, governmental actions, market disruptions that have an adverse impact on the industry to which the company relates”. Where the ‘Cause’ clause includes an event such as ‘engaging in or failing to prevent any activities that could result in harm to the company’s brand or reputation’, make the clause objective with ‘engaging in or knowingly failing to prevent activities that directly and demonstrably result in material harm to the company’s brand or reputation’.
Then there is the question of who will determine if ‘Cause’ has occurred. Once again, first constructs that leave this determination solely to the investors are not unexpected. A more settled position now is to engage a third -party professional to make the determination. However, this too has challenges if the investigating agency is chosen and appointed solely by the investors at their discretion. A balance needs to be drawn to protect the investors’ rights and founder rights on this determination process.
Finally, some overall carve outs need to be considered by founders to protect them from being unfairly held responsible. Typically, investors will have ‘veto/reserved matters’ and in some cases require the company to follow the investors’ policies etc. With these set of rights available to investors, the following carve outs should be considered:
- Investor Approval or Guidance: If an action is carried out by the founders with the approval of an investor or based on the recommendations or suggestions of the investors, the founders may argue that they should not be held accountable if things go awry. The carve-out protects them from being held liable for actions they have taken in good faith and in line with investors’ directives.
- Circumstances Beyond Control: Founders may seek protection from being blamed for circumstances or factors that are beyond their reasonable control and cannot be prevented after having in place necessary internal controls. By including a carve-out for these scenarios, founders should not be held accountable for unforeseeable or uncontrollable events that may adversely affect the business, such as acts by rogue The proviso to this is of course that the founders should have implemented necessary internal checks and controls.
- Alignment with Agreement: This carve-out also aligns with the idea that actions taken in accordance with the specific majorities prescribed under the shareholders’ agreement should not be a cause for penalizing the founders. This demonstrates a joint understanding between the investors and founders about the decision-making framework within the company.
The definition of ‘Cause’ often emerges as a critical point of contention. While the negotiation of a ‘Cause’ clause varies on a case-to-case basis, reflecting the unique characteristics and priorities of the parties involved, it typically embodies a complex interplay between protecting investor interests and safeguarding the rights and concerns of the founders. To navigate this nuanced terrain, the conclusion of such negotiations should ideally be pursued with the assistance of legal counsel whose expertise can shape a definition that is both robust and fair.