How to Create a Simple Cash Bonus Plan to Incentivize and Attract Employees

showmethemoney-Jerry-Maguire-1Your employees, like wide receiver Rod Tidwell (Cuba Gooding Jr.) in the classic movie Jerry McGuire, are valuable commodities.  They will stay with you if offered proper incentives, especially if you “show them the money.”

One of the best ways to do this is to create a simple cash bonus plan.  A cash bonus plan offers employees a financial reward for achievement of corporate, business unit and/or individual goals. The goals can be short-term (e.g., annual or quarterly) or long-term (e.g., three to five years), or both.

The best cash bonus plans are easy for employees to understand and easy for companies to operate. The plan is memorialized in a short written document that is specifically tailored to the company. The company retains the right to amend the plan at any time.

A cash bonus plan can be particularly useful for LLCs and S-corporations that wish to share the economic benefits of ownership with employees without the burdens of issuing Schedule K-1s (with negative tax consequences to employees) or having additional owners with voting and other rights. Cash bonus payments are taxed as ordinary income to employees and subject to standard payroll withholdings and deductions.

A well-crafted plan is a wonderful tool to incentivize and attract high-performing employees.

Here is a summary of the main issues you should cover to create a simple cash bonus plan:

  1. Purpose. The purpose of the plan should be stated clearly so that employees understand its goals, such as “to attract and retain superior employees by providing a competitive bonus program that rewards outstanding performance.”
  2. Eligibility. To be eligible, an employee must typically work at least a minimum number of hours (e.g., 40) as a full-time employee. Employees who have been terminated or who have resigned prior to the bonus payment date are usually ineligible, as are temporary workers. Companies may implement special eligibility requirements as they deem appropriate.
  3. Funding Metrics. The bonus pool can be a percentage of company net income, adjusted net income, earnings before interest, taxes, depreciation and amortization (EBITDA), or any other pool of money that the company identifies. The pool is generally capped as a percentage of the chosen metric.
  4. Performance Goals. Performance goals should clearly describe the metrics that the employee is required to achieve to earn a bonus, and how award determinations are made. Goals should align corporate, business unit and individual performance targets with company interests and encourage teamwork, while retaining incentives for individual performance. Many plans define the maximum target bonus available to each plan participant at the beginning of the performance period if all goals are achieved. Goals may be separated into organizational and individual categories, such as corporate goals to increase earnings and individual goals for productivity, customer satisfaction and client procurement/retention. Goal categories may be weighed (e.g., 50% EBITDA, 50% individual) to encourage one factor over another or equal weight in each category, depending on company objectives. However, the simplest, most easily understsood plans tend to be the most successful.
  5. Bonus Payments. Bonus payments are customarily made within 30-60 days after the end of the performance period (e.g., quarter or year). Bonus payments may be prorated for employees who take approved leave, including maternity or parental leave, and according to date of hire.
  6. Calculation Method. The bonus payable to each employee may be calculated as a percentage or multiple of annual base salary or as a percentage of the bonus pool. Bonuses are often capped at a certain amount.
  7. Non-Assignment. Bonuses should be non-assignable to prevent incentives from being mis-directed. IRS private letter rulings require S-corporations to prohibit assignment of bonus rights to prevent classification of the bonus as a second class of stock.
  8. Withholding. All bonus payments should be subject to applicable deductions and withholdings for federal, state and local taxes, and any other required deductions.

If you are interested in creating a simple cash bonus plan for your company, please contact me at john@jmdorsey.com.

Photo credit: ‘Show me the money!’: Tom Cruise as Jerry Maguire

Sponsorship Agreements: Rights of First Negotiation (ROFNs) and Rights of Last Refusal (ROLR)

In a previous article, I discussed Rights of First Offer (ROFOs) and Why You Need Them in your sponsorship agreement if you are a sponsor.  But if you are not the sponsor and instead you are the event or other sponsorship rights-holder, the ROFO will limit competitive bidding for your valuable sponsorship rights and may therefore decrease your sponsorship revenue.

For this reason, if a sponsor seeks to include a ROFO in a sponsorship agreement, the event or other rights-holder should usually either (i) reject the ROFO or (ii) change it to a Right of First Negotiation (ROFN) or Right of Negotiation (RON).  The ROFN is the common middle road approach used in sponsorship agreements.

Below I discuss both the ROFN and the RON, as well as the Right of Last Refusal (ROLR), which is sometimes used in conjunction with the ROFN/RON.

  • Right of First Negotiation (ROFN).  The ROFN requires the grantor to first and exclusively negotiate with the sponsor for a thing (e.g., renewal of the sponsorship or new rights) for a defined time period before negotiating for the thing with any third party. The ROFN is only triggered if the grantor makes the thing available.  For example, if there is no event or no new sponsorship rights are made available during the ROFN period, then the ROFN does not come into effect and expires. The only obligation the ROFN typically imposes on the parties is to negotiate in good faith.  If the sponsor and the grantor fail to reach an agreement for the thing within the defined period, then the grantor is free to negotiate and enter into an agreement for the thing with any third party, assuming the sponsor does not have a Right of Last Refusal (ROLR) (described below).  Here is a sample sponsor-friendly ROFN clause that is derived from a deal I worked on:

“If the Company or any of its affiliates organizes an Event at any time in any part of the world during the 2-year period following the 2017 Event (the “Future Event“), Sponsor shall have the exclusive right of first negotiation to purchase the same rights granted under this Agreement for the Future Event. On the date that the Company makes the final decision to hold the Future Event, the Company shall give written notice to Sponsor that it will hold the Future Event. Beginning on the date that Sponsor receives such notice and ending sixty (60) days thereafter, the parties shall negotiate in good faith to enter into a definitive agreement for the Future Event.  If the negotiations do not result in an agreement during the negotiation period for Sponsor to sponsor the Future Event, the Company may enter into negotiations with third parties with respect to the purchase of such sponsorship rights, or any other rights, and may proceed, in its sole discretion and without further obligation to Sponsor, with the sale of such sponsorship rights, or any other rights, to any third party.”

  •  Right of Negotiation (RON).  The RON is the same as the ROFN except the RON is not exclusive and does not give the sponsor a first priority in negotiation. Since the RON is nearly the functional equivalent of negotiating for the thing on the open market, it has little economic value and is not customarily used.
  • Right of Last Refusal (ROLR).  The ROLR is sometimes implemented in connection with a ROFN or RON.  If the sponsor and the grantor do not reach a deal for the thing during the ROFN/RON period and the grantor subsequently receives an offer from a third party for the thing, the ROLR gives the sponsor the right to match the third party offer during a defined time period.  A potential drawback of the ROLR for the grantor is that may discourage third parties from negotiating with the grantor for the thing since they know they may be outbid.  On the other hand, if there is significant interest among third parties and the ROLR holder, the grantor may be able to use the third party bids as a stalking horse to increase the price payable by the ROLR holder.  That said, ROLRs are not customarily found in sponsorship agreements, and in most cases the sponsorship recipients should avoid them because (i) they are more likely reduce third party interest in sponsorship assets than to increase the price of those assets and, (ii) perhaps more important, they complicate sponsorship negotiations for management.

Portions of this article were inspired by the article, Rights of First Negotiation, Offer and Refusal by PracticalLaw, a tool I use in my law practice.

Term Sheets: Five Legal Tricks To Make Them Work For You

One of my first questions when asked to draft the agreement for a client’s new business deal is whether a term sheet (also known as a letter of intent or summary of terms) has been prepared.

A term sheet is a short and sweet document that sets out the parties’ mutual understanding of the main terms they will agree on in a later definitive agreement. The key word is mutual: while you and your counterpart may have agreed a deal over a nice wine dinner, your individual perceptions of the main terms may actually be different than you believe. To the rescue comes the term sheet to crystallize the basic terms on which both parties agree and serve as a road map for drafting the definitive agreement. The act of preparing the term sheet also allows you the contemplative time to assess opportunities or risks you may not have previously considered.

In this way, the term sheet helps prevents misunderstandings at an early stage and saves valuable time and attorney’s fees when drafting the definitive agreement. Once complete, the term sheet symbolically bolsters the parties’ commitment to the deal and focuses negotiations.

Term sheets are commonly used for M&A and financing transactions, as well as commercial deals, such as joint ventures, IP licenses, sales of goods and services, and executive employment agreements. Of course, if your deal is simple, you can skip the term sheet and draft the definitive agreement. If not or if there is any doubt, then use a term sheet.

Here are five tricks of the trade to help you draft term sheets to your advantage:

  1. Prepare the First Draft. There is no convention as to which party prepares the first draft of a term sheet, but I advise my clients to prepare the first offer because it can become the anchor for negotiation (as demonstrated in compelling psychological studies). Also, if your adversary later seeks to change your terms, you can argue, “Well…I gave up X from my first draft, so I will need Y” in the next draft. Often “X” will be a slight reach, so “Y” may not be the fallback it appears. To use the first draft to your advantage, however, your term sheet should be a reasonable first shot at crafting the basic deal terms (i.e., no excessive overreaching, which may erode your credibility and associated negotiating leverage).
  2. Make it Non-Binding (Usually). The general rule is that the term sheet should not be legally binding. There are exceptions to this rule, such as binding obligations of exclusivity or confidentiality included in acquisition transactions or other special cases in which a party will intentionally seek to bind the other party in furtherance of its goals. The key is to avoid unintentionally binding obligations. Courts review several factors to determine whether a term sheet is binding, such as the language used, the definitiveness of the terms (e.g., are there remaining terms to be negotiated?), and the context of negotiations. If there are binding provisions, both binding and non-binding provisions should be clearly identified. Non-binding term sheets should not be signed and should also include non-binding boilerplate, such as: “This term sheet is for discussion purposes only and is not intended to be construed as a binding agreement. The parties do not intend to be bound until they enter into definitive agreements regarding the subject matter of this term sheet.”
  3. Focus on the Big Issues. The term sheet should cover only the main deal points. It should not include every potential contract detail. Remember that this is a short and simple document, preferably one- or two pages maximum. The idea is to agree on the big picture items and defer the details to the definitive agreement. For example, in a minority investment in an LLC, the big issues might be the purchase price, pre-money valuation and number/percentage of outstanding shares to be acquired, director/manager appointment rights, other minority investor rights, pre-closing conditions, and the projected closing date.
  4. Use Catch-Alls and Conditions to Cover Future Needs. You should use catch-all phrases in the term sheet to preserve your right to include additional terms in the definitive agreement to cover anticipated and unanticipated issues. For example, in a term sheet for a licensing deal, you could say: “The definitive agreement will include additional terms and conditions customarily included in comprehensive [insert type] license agreements.” This sentence gives you the flexibility to include a variety of additional terms in the definitive agreement while staying within the symbolic boundaries of the term sheet. Similarly, if you need to conduct more diligence or obtain financing, then you could say: “The possible transaction is subject to additional due diligence by [buyer] to [buyer’s] satisfaction, as well as [buyer] being able to obtain financing necessary to complete the transaction.” Without these catch-all and conditions provisions, your counterpart may argue that terms you later request should not be included in the definitive agreement because they were not mentioned in the term sheet.
  5. Use Assumptions to Protect Against Unknowns. At the term sheet stage, the parties have typically not conducted substantial due diligence and open questions remain regarding known unknowns and possibly unknown unknowns.  You should use assumptions in the term sheet to hedge against this uncertainty. For example, if your willingness to pay a price for a target company is based on certain assets being transferred to the company at closing, then state the assumption in the term sheet so you have the ability to change the price without disrupting the deal if the assumption proves false.

By using these five tricks of the trade (and the advice of a good lawyer), you should be able to prepare a simple term sheet that serves as a foundation for the successful negotiation and drafting of the definitive agreement for even the most complex of your business deals.

Your Right to Terminate: Quite Possibly the Most Important Right In Your Business Contract

It’s almost inevitable. At least three or four times a year, the phone will ring or an email will arrive with the client saying something like this:

“John, it’s not going as we had hoped. We need to know how to get out of this deal, and the consequences. How soon can you review the contract?

Rewind 6-12 months prior to this message, when the sky was blue, the birds were singing, and this was going to be the best deal in history. Indeed, the parties’ unbridled enthusiasm to work together on a new transaction is one of my favorite things about being a deal lawyer. This enthusiasm provides the foundation momentum to swiftly negotiate and close the transaction.

In an acquisition, the seller is happy to cash out and the buyer is eager to add new assets to its portfolio. In a joint venture, the parties are keen to make a whole greater than the sum of its parts. In the hiring of a new employee or consultant, the company appreciates adding human capital and the employee or consultant relishes the new opportunity.

But after the deal is signed and the honeymoon period fades, assets may be prove defective or deficient, personalities may clash, performance may falter, and other unexpected challenges may arise.

When this happens, the most important contractual term is not the price you negotiated, the assets you have the right to buy, or the services or other items you are supposed to receive. Instead, the most important term is your right to terminate the deal, including the ability to cut your losses (or increase your gains) and return to the status quo (or enhance your position).

Without the right to terminate, you could be forced to return to the negotiating table for settlement discussions on a termination agreement. This may involve an expensive settlement payment plus attorneys’ fees, in addition to the cost of your valuable time and emotional capital. In the worst case, it could mean mediation, arbitration, or litigation. Meantime, you may need to continue to honor burdensome obligations under the existing contract, ratcheting the pressure on an already tense situation.

Conversely, if you have strong termination rights, you may be able to leverage a termination situation to your advantage. Your leverage may allow you to end the agreement unilaterally, but it may also enable you to re-negotiate the deal to achieve better terms or to salvage a challenging relationship by changing expectations.

The termination clause and its related provisions are so important that when I negotiate deals for my clients, I read them and re-read them several times as we iterate and revise drafts. When negotiating complex deals, I often lie awake in at night weaving the termination and post-termination rights provisions in my mind, making sure they fit and function in my client’s best interests.

While we all hope that each business deal is a success, when negotiating your agreements it is important to take a moment to envision your rights and remedies if the relationship does not evolve as favorably as anticipated. Your lawyer should help you craft deals that enhance your upside but also protect you from downside risks, which include the right to terminate the deal when things go awry.

Nine Signs Your Proposed Business Deal Might Not Pass The Smell Test

One of the benefits of being a corporate lawyer is the opportunity to participate in a variety of interesting deals.  In these, you encounter a motley crew of characters.  You witness a range of negotiating styles and tactics, and learn which are effective and which are not. You see some ventures succeed and many others fail.

In the great theatre of the deal, there are rare moments in which something may not feel right to the lawyer or the client about a proposed business transaction or partner.  The thing amiss may only be verifiable by circumstantial evidence.  To paraphrase the Delaware Chancery Court, it may be that the circumstances surrounding the person or transaction stink bad enough that they simply do not pass the “smell test“.

Questions may arise following diligence on the target (which should minimally include Google and litigation searches), from a person’s conduct in negotiation or from other third party sources.  There will not typically be any proverbial smoking gun, so your judgment and careful diligence will be your guiding light.

In my years as a deal lawyer, the appearance of any of these nine elements (not in any order of priority) has been a fairly reliable harbinger of difficulty, dishonesty or even fraud in proposed business deals.  If any of these elements arise in your dealings, you should consider diving deeper into diligence to determine if there is genuine cause for concern or possibly re-negotiate or abandon the deal altogether.

  1. The demanding long-winded negotiator of trivial things.  Excessive demands for non-substantive or patently unreasonable changes to the initial non-binding deal document, such as the term sheet or letter of intent, may foreshadow protracted and possibly agonizing negotiation of the definitive agreements and a challenging ongoing business relationship.  If the demands are coupled with the party’s long-winded or repetitive arguments why he is right and you are wrong (or other ridiculous anectdotes), they may suggest personality issues.  In my experience, character defects are not easily remedied and often worsen with time. The unreasonable negotiator should distinguished from the tough savvy negotiator, who requests substantive deal points but is often reasonable and a good business partner after the deal is papered.
  2. The deal requires urgent participation and won’t be available after “X” occurs.  This is the classic illusion of scarcity tactic.  If your prospective business partner claims that if you fail to act now, (i) a large investment from Mrs. “Y” will soon be received and the price of the investment will increase or (ii) the deal will not be available for “Z” reason, the claim may be a red herring and should be carefully scrutinized.  Fictional future money is sometimes characterized as coming from abroad or from some well-known person with whom the partner purports to have a close relationship.
  3. The secrets that cannot be revealed.  If the target’s founder or your prospective partner is unwilling to reveal certain fundamental aspects of the business or how it expects to make money, the company may not have a business plan.  You have a right to know the company’s business model and growth strategy, with the understanding that the model will likely evolve over time. In one startup deal I reviewed for a client, the founder made repeated excuses why he could not provide information about critical company inventions and provisional patent applications.  Later diligence revealed that the company had no inventions and its business plan was impracticable. After spending the other investors’ money, the founder abandoned the company and the U.S.  This is akin to Bernie Madoff’s “black box” investment strategy that was “so good” that it could not be understood or replicated by any reputable investor.
  4. The anonymous “big money” partner.  Any person who must remain anonymous is often a red flag, particularly if this mystery man is a primary financing source.  A client once instructed me to prepare the draft documents for a “big investment by a Chinese investor who needs to remain anonymous.”  A third party had informed the client that the Chinese wanted this, that, and the other, and I prepared several draft iterations at the client’s request.  The Chinese investment never materialized and the client wasted money on legal fees. Some celebrities and others have genuine reasons to protect their privacy, but if you are doing a deal with someone (including a celebrity), you have a right to know their identity and to size them up.  Always insist upon lifting the veil of anyone who says they must remain anonymous.
  5. The shell company spider web.  Domestic and offshore entities are often formed to execute lawful business strategies, including liability and tax mitigation, particularly for companies with substantial non-U.S. source income.  But as the Panama Papers confirmed, offshore shells with limited assets may also be created for tax evasion and other corrupt purposes.  Before doing any deal with a company that owns or operates affiliates, especially offshore shell entities, you should fully understand the organization chart and confirm that each entity exists for lawful and legitimate purposes.
  6. The paperless office.  It is fine if your partner keeps a clean desk and operates in the cloud, but a lack of paperwork memorializing a business’s structure, assets and operations is almost invariably a red flag.  You should have access to reasonable diligence paperwork and you should be able to freely ask questions and to have them answered.
  7. No skin in the game.  If the deal does not require your business partner to put money or something else of value into the deal, your interests may be de-aligned from the beginning.  In the startup context, this could be the situation where a founder’s shares are fully vested from day one and he has no invested capital or other hook to prevent him from walking away when the going gets tough or he receives a better offer.  In a joint venture, it could be the ability of a party to enrich himself at the expense of the venture.  De-alignment can usually be remedied by careful drafting of the legal incentives in the deal documents.
  8. The promise of abnormally high or guaranteed returns. This trick is as old as prostitution: returns above market rates or guaranteed returns on invested capital are often signs of a Ponzi scheme, where the prompter lures you to invest to pay his prior investors rather than to make bona fide investments with you money. You should always determine the source of returns and whether that source is capable of generating the projected payout.  Most financial projections are exactly that, and vary dramatically from actual results.  There is no such thing as a guaranteed return.
  9. It sounds too good to be true.  This is a corollary of abnormally high returns.  As the adage goes, if what you are to receive in exchange for your participation sounds too good to be true, then it probably is.  In most of these cases, you should run away from these deal absent a reasonable and verifiable justification for its sweetness.