What Should Small Business Owners Know About Severance Agreements?

Date: March 30, 2017

Though once thought to be the dominion of large corporations and high-level executives, small businesses are increasingly utilizing severance agreements to minimize potential liabilities. Indeed, a severance agreement should be considered as a potential tool for safeguarding your interests—while hopefully parting on amicable terms—when discontinuing an employment relationship. But it is essential to understand that severance agreements have both advantages and disadvantages.

On the positive side, a severance agreement can help affect a clean break with an employee; however, they can also present pitfalls. To be sure, severance agreements are not appropriate in all situations. This article seeks to outline some of the pros and cons, so that you can begin to think about whether a severance agreement may work in your situation.

What is a Severance Agreement?

First, let’s start with the basics. A severance agreement is like any other contract—meaning that it’s an enforceable agreement. For a more general discussion on contract formation issues, check out our recent post explaining what small business owners need to know about negotiating contracts. But for our present purposes, it suffices to say simply that a severance agreement sets out the terms on which an employment relationship will end—typically with an offer of some monetary benefit to the employee in exchange for an agreement to leave quietly.

Of course, one can terminate an employee without offering a severance agreement. For that matter, in most states employment may be terminated at any time for any (legal) reason through a variety of different mechanisms without need for special formalities. But the potential advantage in offering a severance agreement is that the employee may be willing to make important legal concessions in exchange for a lump sum payout, or a temporary extension of salary and or benefits. Indeed, as with all contracts, the parties involved (i.e., the employer and soon-to-be terminated employee) must each exchange something of value – which in contract law is called “consideration.” For example, as a condition of accepting a proposed severance package, the employee may agree to a non-compete clause (i.e., promising not to compete with the employer for some defined time period), a confidentiality clause (e.g., promising to not reveal knowledge gained about the employer’s business practices and trade secrets), or a waiver/release of claims against the employer (i.e., promising not to sue).

What are the Benefits of Offering a Severance Agreements?

Liability Issues. As suggested already, a primary benefit of using a severance agreement is that it may limit a business’s liability in requiring the employee to waive or release any potential claims he or she might have against your company. This may be a helpful way to alleviate a potentially sticky situation, or simply to minimize the risk that a disgruntled former employee may bring a baseless lawsuit—which may be a huge cost saver, if you consider the money you may otherwise have to invest in defending a lawsuit. For this reason, a common component of a severance agreement is some sort of waiver or release clause, wherein the employee agrees to not pursue any legal claim he or she might have against the employer. But you should know that the law may prohibit waiver agreements for certain legal claims, or may carefully dictate how and when an employee may waive such a claim. As such, you should consult an employment attorney licensed in your state for guidance on how these laws may affect you and your contemplated severance agreement.

Confidentiality Concerns. Severance agreements may also help maintain the confidentiality of trade secrets, proprietary information, and or business techniques and practices. Confidentiality agreements may also be desirable if you want to ensure that a former employee will remain silent on internal disputes, disagreements or other matters that might not reflect well upon your company. Understandably, no one wants their dirty laundry aired publicly. And this may be an issue of special concern in the social media age.

In any event, businesses often want to include confidentiality agreements in severance packages for pragmatic reasons. For example, your company may have amassed proprietary information (customer lists, etc.) or may utilize proprietary techniques or practices that allow you to remain competitive. Accordingly, when an employee with knowledge of information or techniques leaves, it’s entirely reasonable to be concerned about what that employee will do with this knowledge. This is especially true if the former employee is hired by a competitor or intends to start his or her own business. As such, severance agreements often include a confidentiality clause limiting or prohibiting the use of proprietary knowledge accrued and skills gained in the course of employment. It may just as well prohibit the former employee from talking or writing about sensitive subjects.

Non-Compete Clauses. Additionally, a severance agreement might help reduce the risk of future problems if you anticipate that the departing employee may go into business in competition with your company. While some of those concerns may be addressed through confidentiality agreements, a severance agreement may include terms imposing geographical or temporal restrictions on how and when a departing employee may engage in direct competition with your business. Of course, it is important to understand that courts may sometimes refuse to enforce overly restrictive non-compete clauses, and that in certain rare cases—i.e., if a business has attained a monopoly for a specific geographical market—non-compete agreements may also raise problems under antitrust law. Accordingly, it’s prudent to consult legal counsel before asking an employee to agree to a non-compete clause.

Are there Drawbacks?

Despite potential benefits, severance agreements are not a panacea. One obstacle is financial. To be sure, not all businesses can afford to offer a severance package. This is especially true if the employee was let go for economic reasons. But as a more general proposition, small businesses often lack the financial resources that larger firms have.

Another pragmatic problem is that an employee might opt against signing a severance agreement. And of course, there is a certain risk that by offering a severance agreement you may be flagging to the employee that you may have concerns about potential liabilities—which may potentially undercut your goals. To be sure, the last thing you want to do is to plant the idea in the employee’s mind that he or she might have a claim against your company. Accordingly, its crucially important to discuss these potential risks and the best approach for proposing a severance agreement with a trusted attorney.

Where can I find a Model Severance Agreement?

If you think your business could benefit from a severance agreement, you might consider this template, from the Society of Human Resource Management, as a useful starting point: Sample Separation and Release of Claims Agreement.

*NFIB makes no representations about this form or the information contained in the form. Once again, you should consult with an employment attorney licensed in your state before entering into a severance agreement with an employee.

What Else Should I Keep in Mind When Terminating an Employee?

Lastly, you may want to go back and review the materials we’ve posted previously on termination issues. Specifically, check-out this webinar discussing what small business owners need to know about hiring and firing employees. Additionally, you may also benefit from reviewing our free guides to federal employment law, wage and hour, and more.

Additionally, readers may also find helpful guidance that we put together recently on contractual negotiations, and on handling contractual disputes.
*This article does not provide legal advice. Businesses are advised to retain counsel from a trusted attorney with experience in employment law.

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