For Japanese corporate venture capital (CVC) investors, involvement with US startups comes with a host of labor and employment issues to consider. These include the variety of regulations relating to discrimination, working hours, workplace safety, employee leave, and at-will employment, which need to be considered with an understanding of the distinctions between federal and state/local regulations. CVC investors should particularly focus on employee retention, confidentiality, non-compete, and non-solicitation that could affect the future success of the startup. Below is a summary of key labor and employment issues related to transactions for CVC investors.
POINTS ON DUE DILIGENCE
- Perform thorough due diligence to identify the risks of a startup founder or key employees leaving. In startups, founders and executives play integral roles in the technical and managerial success of the startup. Losing those key figures after an investment could prove disastrous. Employees who leave the company to work for a competitor or take confidential information or technology rights on departure could also hurt the investment.
- Make sure to identify these risks early on and take steps to reduce the likelihood of these situations, including securing technology rights and improving employee engagement.
- Other employee retention measures include appropriate closing conditions in investment agreements, incentive and stay bonuses, and non-compete and non-solicit covenants.
- Investigate the employment terms and conditions for key employees. Review whether important executives and employees have stock-based compensation or other items that could cause a change in the post-investment ownership interest and whether there are any payments triggered by resignations, potential changes in employment conditions or other financial expenditures. In addition, be aware of pending or potential legal disputes involving trade secrets, patent rights, or discriminatory treatment.
- Understand employment contract provisions. Employment contract provisions dealing with confidential information, invention assignment, or non-compete or non-solicit agreements may be held differently from state to state and from common understanding in Japan.
- Get familiar with startup compensation arrangements. Equity compensation plans are common at startups and typically include restricted shares, stock options, restricted share units, and/or performance share units. Each has its own features and conditions.
NON-COMPETE PROVISIONS
If considering the use of non-compete provisions in contracts, which bar an employee from engaging in a competing business or signing on with a competitor after retirement, it should be noted that they do not necessarily carry the same validity in the United States as they do in Japan, and their applicability can vary from state to state. Furthermore, a proposed rule from the US Federal Trade Commission could ban use of these clauses.
KEY TAKEAWAYS FOR STARTUP INVESTMENT
- Correctly identify the executives and employees who are essential to the conduct of the business at the time of due diligence and confirm the policy for dealing with them.
- Perform careful due diligence, including agreements with executives and employees, to understand potential legal disputes regarding employment.
- Incorporate provisions in investment contracts to prevent, as much as possible, the turnover of executives and employees who are indispensable to the execution of the business.
- Keep in mind it is becoming harder to enforce post-retirement non-compete covenants in agreements with individual executives and employees.
- Involve the legal, human resources, and business departments to carry out due diligence and analyze post-closing policies.
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