Don’t allow startup execs to forfeit salaries

In thriving venture communities such as Greater Boston and Silicon Valley, many early stage entrepreneurs agree to forfeit or defer compensation until the startup attains certain financial goals.

While these stakeholders typically recognize the need to pay rank and file employees a minimum wage on a timely basis, they often believe that senior executives, especially those who receive an equity stake, are exempt from such requirements or can elect to waive their rights to such compensation. In many jurisdictions that belief is wrong.

Under Massachusetts law, for instance, no employee—even a senior or controlling executive—can waive his or her right to receive timely payment of earned wages. If an executive who previously agreed to forfeit salary later sues his or her employer, that company and certain officers face significant liability risks—criminal as well as civil—and its shareholders could see their prospective returns devoured. This article discusses current Massachusetts law, including an Appeals Court decision published in August, concerning the application of Massachusetts wage statutes to highly paid employees, and offers some practical advice on how to mitigate the law’s draconian effects.

Current law

Like California law and the law of many states regarding the payment of wages, Massachusetts statutes provide minimum standards for when, how much and to whom “wages” must be paid.1 Massachusetts law requires employers to pay employees on a regular schedule, which may be monthly in the case of executive, administrative and professional employees who are exempt from overtime laws. The statute’s express purpose is to prevent the unreasonable retention of wages.

A second statute governing the payment of minimum wages expressly applies to all employees, with only limited exceptions.2 While federal law provides an exemption from both minimum wage and overtime pay for certain highly compensated executives, Massachusetts law has been less clear.

Until recently, a majority of cases suggested that the Payment of Wages Act (“Wage Act”) did not apply to highly compensated executives and was meant to protect only rank and file employees. The statute does not exclude highly compensated professional employees, however, and expressly requires “every person having employees in his service” to pay them their earned wages. Anyone who engages any employee for compensation is an employer under the statute, without regard to the number of employees or the company’s financial performance.

Several years ago, a superior court judge ruled that the statute protects highly paid employees, and distinguished earlier cases by finding that they had not held the statute inapplicable to highly compensated employees, but merely excluded from the statute’s definition of “wages” several forms of compensation commonly received by such workers, such as bonuses, commissions and stock options.3 The decision increased the stakes of deferring payments to entrepreneurs, as it suggested that the highly compensated employee might have redress not only for contractual remedies arising from his or her written agreements, but also statutory remedies for unpaid or untimely wages.

Indeed, a Massachusetts judge later held that the decision of a Massachusetts employee to voluntarily defer her salary until the company’s financial situation improved was void. After the parties’ relationship soured and she was terminated, the employee thought better of her deferral decision, and the court permitted her statutory claim to proceed. It found that her wages were earned, were not tax-exempt deferred compensation falling outside the definition of “wages” and her receipt of payment depended only on the company’s financial ability to pay, which is a prohibited contingency.4

The court candidly conceded that “enforcing this provision in the Wage Act may adversely affect those startup companies which ask employees to forego wages until the company reaches financial viability.”

The Wage Act confers a substantial benefit on highly compensated employees seeking redress. Unlike in contract actions, successful statutory claims under the Wage Act permit recovery of treble damages and attorneys’ fees. Corporate officers who are responsible for making wage payments to employees can be held personally liable. The personal liability risk is not limited to officers, either. At least one Massachusetts judge also held an outside investor who assumed certain management functions personally liable for unpaid wages.5

A companion statute governing penalties for violation of the wage statutes6 also imposes criminal penalties on the company and certain officers. Liable officers face fines and imprisonment for willful offenses and for retaliating against those who complain about violations. Finally, a company in violation of the statute could even be debarred from doing business with the Commonwealth and its agencies.

On Aug. 20, 2007, the Massachusetts Appeals Court offered further clarity by expressly ruling in Okerman v. VA Software Corp., 69 Mass. App. Ct. 711 (2007), that the Wage Act applies to the highly paid worker. The decision overturned the rulings of two prior superior court judges by permitting a highly compensated professional to sue under the Wage Act for definitely determined, due and payable unpaid commissions, even though he had received nearly a six-figure base salary. The court noted that “despite any original intent of the statute as a means to provide compensation to aggrieved weekly [modestly compensated] earners, one may now discern a legislative intent to apply the benefits of the statute to current-day employees … including executives and professionals earning a substantial base salary plus commissions.” Id. at 1123 n.9.

Practical advice

In organizing a startup, what do you do about compensating the executive team? In many companies, compliance will require changes to pay-day policies, may alter a conscientiously informal business culture and could even result in higher capital contribution requirements.

With very limited exceptions, employees based in Massachusetts need to receive timely payment of a minimum wage. Accordingly, the company should adopt a policy that follows this rule for its Massachusetts employees. Although top executives probably have not been paid a true minimum wage since they were wearing short pants, once they understand the law’s requirements they should be willing to document their compensation arrangements to ensure timely payment of sufficient wages.

The recent Massachusetts Appeals Court decision reminds investors and entrepreneurs alike of the dangers of underestimating the scope and bite of payment of wages laws.

Ronan O’Brien and Kristin McGurn, Partners, Seyfarth Shaw LLP

In terms of company culture, the founders need to be clear that no employee should have any expectation of any guaranteed deferred salary or other compensation. Handshake arrangements or “side deals” could haunt the founders and their investors later. Finally, the founders need to ensure that at all times there is sufficient capital to meet the financial burden of paying earned wages for as long as they operate as a going concern. As a result, the founders may need to ante up more capital initially, especially for an unprofitable or pre-revenue enterprise.

What do you do if you already have agreements with executives to defer all salary? Every case is different and each situation should be reviewed with qualified counsel. As a general matter, if a company with Massachusetts employees lacks the means to pay the executives the “deferred” salary right away, the company should consider taking two steps immediately. First, it should evaluate whether arrangements that fully defer salary can safely be terminated. This evaluation should include careful consideration of potentially complex tax and accounting implications, including the effect of acceleration under Section 409A of the IRC.

Ideally, the company should commence paying minimum wage (at least $455 per week) to each executive, whether or not reformation of agreements is advisable. Portions of salary that previously would have been casually deferred might then be structured as a bonus payable once the company attains the same financial metric that would have triggered the payment of the deferred salary under the old regime. Of course, initiating this policy change might alert an executive to a potential claim against the company. Given that danger, a founder or investor might wonder if the cure is worse than the disease. However, with symptoms like treble damages, attorneys’ fees, personal liability for officers and the potential for criminal sanction, it’s a bitter pill worth swallowing.

Second, the company should try to immediately discharge its liability. Of course, some startups may lack the necessary funds to completely repay the debt. In such a case, the company should be ready to demonstrate good faith in addressing its mistakes. For instance, the company could enter a written agreement with each executive that sets forth its obligation and begins making payments to discharge it.

The company might also ask its founders to make capital contributions to the business to permit at least partial payment of the outstanding amount right away. While such steps might not prevent a court from ultimately awarding damages to a plaintiff, at least one Massachusetts court refrained from imposing treble damages because it viewed the company’s pre-suit repayment effort as evidence of its good faith.7

Conclusion

When it comes to venture-backed startups, overcompensating executives is rarely the issue. Venture capitalists take care to align the interests of management with the success of the enterprise. However, less attention is paid to the significant liabilities that arise from “undercompensating” executives. The recent Massachusetts Appeals Court decision reminds investors and entrepreneurs alike of the dangers of underestimating the scope and bite of payment of wages laws.

Some of the dangers of non-compliance are obvious, such as the risk of criminal sanction or the effects on investment returns. But even greater dangers lurk. For instance, following the sale of the business, could the purchaser sue the original owners for fraud for failing to disclose potential liability for violations of the Wage Act? Worse yet, might a well pled fraud claim persuade a court to nullify all limits of liability in the acquisition agreement?

Ronan P. O’Brien and Kristin G. McGurn are partners in the Boston office of Seyfarth Shaw LLP representing entrepreneurs, venture capitalists and mid-sized businesses.Footnotes

1. Mass. Gen. Laws ch. 149, § 148.

2. Mass. Gen. Laws ch. 151, §§ 1 and 2.

3. Kohli v. RES Eng’g, Inc., 2000 WL 1876605 (Mass. Super. Dec. 19, 2000).

4. Dobin v. CIOview Corp., 2003 WL 22454602 (Mass. Super. Oct. 29, 2003).

5. O’Leary v. Henn, No. 120170-65 (Mass. Super., 2005).

6. Mass. Gen. Laws ch. 149, § 27c.

7. Dobin, 2003 WL 22454602 at *8.