How to Terminate Employees at your Startup

author avatar by Bryce Warnes • 7 min

Hire slow, fire fast, says a popular rule of thumb. Take your time to find a good fit for your company—but if a team member is dragging you down, let them go ASAP.

If you have to fire someone, a quick, clean break is the most appealing approach. But rushing to remove an employee and backfill their role can lead to mistakes—like forgetting to obtain a signed separation agreement along the way.

Later on, that can send danger signals to potential investors, and damage your ability to raise funds.

Here’s everything you need to know about how to terminate employees without putting yourself in a compromising position.

Employment agreements and the termination clause

Your cheat sheet for employee termination can be found in the employment agreement you and the employee in question signed when they began working for you.

Most employment agreements—including those provided by Capbase, as part of your document room—include a termination clause. This clause lays out your employee’s legal obligations if quitting, and your legal obligations when firing them.

The termination clause determines:

  • How much notice you must give an employee when they are terminated
  • How much severance you are obligated to pay upon termination
  • How much termination pay you may owe an employee in lieu of notice

It’s important that, when you sign an employment agreement with a new hire, the termination clause is up to date. Employment laws change with time, and a termination clause that violates current employment laws may, in court, be deemed invalid.

(Capbase’s employment agreement template is drafted, maintained, and updated by a team of lawyers, so you never have to worry about it being out of date.)

What happens to an employee's equity once they're terminated?

The fate of a terminated employee’s equity depends upon provisions laid out in their equity plan agreement.

Stock clawback

If an equity plan agreement includes repurchasing rights, you may be able to reacquire shares from a terminated employee, whether or not they have exercised their options. This is referred to as a clawback, and companies often use it in their own best interests, rather than their employees’.

Repurchasing rights allow you to buy equity back from employees at the fair market value (FMV) or current value of the stock. Thanks to your equity plan agreement, the employee doesn’t have a say in whether they sell to you or not. If you offer to repurchase stocks, but the employee refuses, you can buy them back forcibly.

Even if the employee has not exercised their right to buy, depending on the provisions of the agreement, you may be able to step in and buy any stock that has vested.

In the words of Sam Altman of Y Combinator, “It’s fine if the company wants to offer to repurchase the shares, but it’s horrible for the company to be able to demand this.”

While some employees may be only too happy to sell back their stock, some may not. Forced repurchasing of equity won’t win you any popularity awards.

The exercise window

Your equity agreement also sets the exercise window for employee stock options. An exercise window is a set period after an employee leaves a company, during which they are able to exercise any vested stock options. Standard exercise windows are 90 days, but you can set them to be longer or shorter.

Even if your exercise window is longer, the employee only has 90 days to exercise their options in order to retain incentive stock option (ISO) status for tax purposes.

Note that the exercise window for stock options is different from the expiration of stock options. The expiry of stock options, set out in the equity agreement, applies even if the employee is still a part of your company. Once they leave the company, the exercise window takes precedence—in essence, it’s the “new” expiry date.

At will termination and employee rights

In very basic terms, when you hire someone on an at will basis, you reserve the right to terminate their employment at any time, for any reason, without notice. Your employee may also quit at any time without giving notice.

There are some important exceptions to this. In fact, according to Betsy Carroll, employment lawyer, “There’s a lot of gray” when it comes to firing someone at will.

Generally, even if someone is employed at will, complications arise if you fire them for:

  • Activities they perform outside of working hours, provided they do not interfere with their workplace performance.
  • Exercising their rights under statutes like the Family and Medical Leave Act and the Fair Labor Standards Act.
  • Actions relating to public policy, such as filing workers’ compensation claims
  • Violating an implied contract in an employee handbook (this varies state to state)

In addition, 11 states (including California) specify that you can only fire someone with just cause, or that you can’t fire employees maliciously or in bad faith.

Even if you fire an employee at will, they may try to sue you, or file claims of discrimination.

In the lead up to firing an employee, be sure to carefully document actions you may be able to use to justify firing them—specific instances of failure to fulfill their job applications, or actions that negatively impact your company.

Then, to make sure you’re acting within your rights as an employer, consult with your lawyer. They can inform you of any local or state-level provisions that may prevent you from terminating someone at will.

Can I offer payment in lieu of notice (PILON)?

If your employee does not work for you on an at will basis, their employment contract may require that you give them notice before they are terminated.

This may not always be practical. For instance, if you are worried about disruptive behavior from the employee, or allowing them ongoing access to confidential information, you may wish them to leave your company sooner rather than later.

If that’s the case, you may benefit from offering payment in lieu of notice (PILON.) So long as there is a provision for PILON in an employee’s contract, you can pay them the amount they would earn during the notice period in exchange for them leaving the company immediately.

So, for instance, if your employee’s contract requires two weeks’ notice before termination, you can pay them two weeks’ salary and have them leave immediately.

However—and this is a big “however”—if the employee’s contract does not include a provision for PILON, you are not legally entitled to pay them in lieu of notice. In fact, doing so puts you in breach of the contract, and could mean you sacrifice protections like post-termination restrictions and confidentiality protections.

Older Workers Benefit Protection Act (OWBPA) and other protections

OWBPA is a federal law that protects older workers from being discriminated against based on their age. If you’re terminating an employee over the age of 40, you may need to offer them additional benefits—including PILON—that you may not offer them otherwise.

Similarly, different states have different laws meant to protect workers from discrimination; under these laws, exiting employees may be entitled to PILON or other benefits. Consult with your lawyer about laws in your state, and the steps you need to take to keep yourself protected.

Signing an employee separation agreement

An employment separation agreement is a legally binding document that protects you from being sued by an employee you’re dismissing. Even though it isn’t required by law, you should consider an employee separation agreement absolutely essential any time an employee leaves your company.

The terms of the agreement should include:

  • Details about the separation. The identities of both parties involved, and the reason for separation (whether it’s a dismissal, resignation, etc.)
  • Severance. Even if you don’t offer a severance package, you must document how much the employee will be paid in lieu of notice, saved up vacation pay they may receive, and anything else you owe them by law.
  • Amount you owe the employee (PILON, vacation days, etc.), and how it will be paid (payment schedule, method of payment.)
  • Tax deductions—namely, your deduction policy (how much you’ve withheld from their salary payments up to this point)
  • Insurance info. In some cases, you may continue to pay into the employee’s health plan (for instance, with group benefits)
  • Non-compete provisions, which prevent the ex-employee from joining a competing company for a specified window of time
  • Confidentiality/non-disclosure, specifying what information the employee is required to keep secret (finances, customer lists, etc.) This will also include exceptions to non-disclosure (often spouses and lawyers)
  • Non-disparagement, explaining what the ex-employee can and cannot say about your company

You may wish to include additional clauses covering the return of company property, references, or your re-hiring policy.

Your contract will be unique, according to your needs, but you can find a template separation agreement here.

How to create an employee termination policy

Your company’s employee termination policy is a document that explains how and when employees are to be dismissed. It acts as a road map to help you navigate employees leaving your company, and it doesn’t only apply to employees who are being terminated. It is also used in the event of resignation, retirement, or the scheduled end to an employment contract.

Why create an employee termination policy?

The employee termination policy:

  1. Ensures you comply with local employment laws
  2. Allows you to remain transparent to your employees
  3. Helps you navigate large scale layoffs
  4. Reinforces your company’s ideals by making clear the causes and effects of disciplinary action

What should an employee termination policy include?

Briefly, your termination policy should include:

  • A collection of all communications between you and the employee, from their first offer of employment to their notice of termination
  • The review process for employees undergoing disciplinary action
  • The company-side logistics of dismissing an employee, including:
  1. Policies pertaining to intellectual property
  2. What happens to the the employee’s stock, options, and other equity
  3. How and when vacation is paid out (Preferably ASAP after dismissal, to comply with W-2 regulations)
  4. What happens to the employee’s benefits (Including the option to continue as an individual subscriber with your benefits provider)

In addition to all of the above, your policy should refer to an employee handbook that clearly lays out performance and behavior expectations at your company.

Your termination policy will be unique, and based on the needs of your company. But, for an example, check out this employee termination policy template from Workable.

Employee termination and investor relations

Terminating employees, and tying up the loose ends after—redistributing equity, if any, and having them sign a separation agreement—is not just a personnel matter. It also affects your relationship to venture capital and other sources of funds.

If a former employee sues you, releases sensitive information about your company, or otherwise becomes meddlesome, it can disrupt a fundraising round.

Before performing due diligence, investors want to know that you have a clear termination policy in place, along with releases signed by terminated employees. Taking care of these small details now saves investors—and your company—from major problems later on.

Employee termination gets much more complicated when the employee you’re trying to fire is one of your co-founders. That’s why it’s important to find the right co-founders early on. Avoid any broken hearts with our guide to finding a co-founder.

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DISCLOSURE: This article is intended for informational purposes only. It is not intended as nor should be taken as legal advice. If you need legal advice, you should consult an attorney in your geographic area. Capbase's Terms of Service apply to this and all articles posted on this website.