Spooky season is finally upon us and because nothing is scarier than a deal stopper, employment law partner Sinead Haysom has put together a list of the five biggest employment red flags that investors look out for in this frightfully useful and (vaguely) Halloween-themed article.
When an investor’s (or buyer’s) lawyers start due diligence, the employment section is often where the proverbial skeletons come tumbling out of the closet. None of these issues are unusual in a growing business, and most are fixable, but they’re cheaper, easier and less stressful to fix before an investor finds them.
The ghosts on your payroll (or not on it)
Many early-stage businesses rely on contractors and consultants, often because it’s quicker and cheaper than hiring. The problem comes when those “contractors” look like employees (e.g. they work regularly, under your management, are part of the team, and take on limited financial risk).
If they are, in reality, workers or employees, the business could be exposed to issues such as unpaid tax and National Insurance (plus interest and penalties), as well as claims for holiday pay and other employment rights. Investors will also want to ensure that business-critical people are committed to the company, which usually entails being employed with a decent-length notice period.
How to fix it
Investors will want to know who is engaged on what basis and why, so you will need to be ready to defend your engagements. Review your consultancy agreements now, focussing on your longest-serving and most valuable consultants. Swap anyone regarded as high risk or business critical onto an employment contract and be prepared to justify everyone else.
Possession is nine-tenths of the law – unless it’s IP
They say possession (get it?) is nine-tenths of the law, but when it comes to IP, having the code on your servers, or it forming part of your product, doesn’t mean you own it. This is where those same contractors mentioned above can cause a second problem.
That’s because IP created by employees in the course of their employment generally belongs to the employer, but the default position for contractors and consultants is that they own what they create unless it has been formally assigned.
So if your platform was built by a freelance developer on a handshake and a shared Google Doc, the company may not actually own the code it runs on. The same can be true of founders who weren’t properly engaged by the company in the early days. Investors are investing in your IP, so they will check that every key contributor has signed a proper assignment.
How to fix it
Review your consultancy agreements to ensure there is a proper assignment of IP. Review your old arrangements, and seek retrospective assignments from those who created IP in the past (even if they are no longer working with the business).
Trick or treat? The “discretionary” bonus
Many bonus schemes are described as discretionary, but this label doesn’t make it so. If the contract or offer letter sets out fixed targets, a set formula or a guaranteed amount, or if the bonus has been paid on the same basis year after year, employees may well argue that they have a contractual right to it.
Even where a bonus is genuinely discretionary, that discretion has to be exercised rationally and in good faith, so a company can’t simply decide not to pay without a proper reason. For investors, this points to potential liabilities that may not be showing in the accounts, and they will want to know what their exposure is.
How to fix it
Review your bonus terms and look back at how your bonuses have been operated in the past. Consider whether it might be better (counterintuitively) to put in place a proper, contractual bonus scheme, so that everyone’s entitlements are clear.
Disputes that won’t stay buried
Employees now have six months to bring a claim against their employer. Once you factor in Acas conciliation taking up to 12 weeks, and tribunal delays in processing the claim, the best part of a year can pass between dismissing an employee and a claim landing on your desk. Investors will therefore want to see that you have robust procedures for fairly dismissing employees, and that any complicated exits have been dealt with by way of settlement agreements.
Discrimination and whistleblowing-related compensation is uncapped (and from January, unfair dismissal compensation will be too), so investors will ask about everyone who has left the business in the last year or two, and will want you to identify any risky ones.
How to fix it
Deal with issues fairly, quickly and robustly (this is particularly important from January when qualifying service for unfair dismissal purposes goes down to six months. Put settlement agreements in place with anyone deemed to be high risk.
The phantom founder contract
We regularly come across founders without proper employment contracts in place (these are also called directors’ service agreements for statutory directors, but they broadly cover the same things). The founders might have a verbal agreement, or some kind of memorandum between them, but nothing formal.
This is a headache for founders because you need to justify to the investor that you actually had been promised a higher salary, you are entitled to that company car, and you are allowed to continue with your university research. If you put these things into black and white early doors, it is much harder for an investor to backpedal, and it stops any last-minute wrangling over terms.
Yes, an investor may still wish to put in their own terms, but if yours are good enough and balanced from the outset, they may not. An employment contract shouldn’t ever hold up a deal, but all too often it is the employment lawyers scrambling around late on completion night trying to agree contracts.
How to fix it
Make sure you have an up-to-date employment contract (or director’s service agreement) for each founder, which is tailored to each director and their outside interests.
Final thoughts
Most of this can be put right with a bit of housekeeping, and it’s far better to find your own skeletons than to have an investor’s lawyers dig them up for you. If you’re planning a raise in the next year or so and would like a second pair of eyes on any of the above, do get in touch – I promise it’s less frightening than it sounds… And last but not least: Happy Halloween!
FAQs
What employment law issues do investors look for during due diligence?
Investors will usually want to understand how people are engaged, whether employment contracts and consultancy agreements are properly documented, who owns intellectual property created by employees and contractors, whether there are potential employment disputes, and whether bonus or incentive arrangements create unexpected liabilities.
Can contractors be treated as employees or workers in the UK?
Yes. Calling someone a contractor does not determine their legal status. If the way they work is more consistent with employee or worker status, the business may face liabilities including tax, National Insurance, holiday pay and other employment rights, including the risk of employment-related claims. Investors may therefore scrutinise long-standing or business-critical consultancy arrangements closely.
Who owns intellectual property created by contractors?
Unlike IP created by employees in the course of their employment, intellectual property created by contractors or consultants does not automatically belong to the company. Businesses should ensure that consultancy agreements contain appropriate IP assignments and consider obtaining retrospective assignments where necessary.
Can a discretionary bonus become contractual?
Potentially. A bonus described as discretionary may still give rise to contractual rights depending on the wording of the employment documents and the way the scheme has operated in practice. Employers should review both the written terms and the history of bonus payments before a funding round or transaction.
Do investors review previous employment disputes during due diligence?
Yes. Investors and buyers may ask about recent dismissals, grievances, employment tribunal claims and other potentially contentious exits. Businesses should be able to explain how those matters were handled and identify any continuing financial or legal exposure.
Do founders need employment contracts or directors’ service agreements?
Yes. Founders who work for the business should have clear written terms setting out matters such as salary, benefits, notice, duties, confidentiality, IP, restrictive covenants and outside interests. A properly drafted employment contract or director’s service agreement can reduce uncertainty when investors review the business, and increase founders’ chances of keeping those terms post-investment.
How can a company prepare its employment documents before an investment round?
Businesses can reduce due diligence risk by reviewing employment and consultancy agreements, confirming IP ownership, checking bonus arrangements, documenting founder terms and addressing unresolved or potentially contentious employee exits before investor scrutiny begins.
