What is a Key Man Clause? (Silicon Valley x LexStart)
Silicon Valley: S02E01 (Part 3) - Peter Gregory’s death triggers a “key man clause” within Raviga, the investment firm of which he was the Managing Partner. What is a key man clause? In the show, we see Bachman explain the concept to Richard.
Investment decisions are based on the ability of the key personnel to efficiently run an entity. What happens if the `key man’ or one of the `key men’ suddenly dies or is unavailable to render his services for any reason whatsoever? This is where a `Key Man Clause’ comes into picture.
Through this blog post, we bring to you a discussion on what is a Key Man Clause, why it is important and how it is drafted and implemented.
What is a Key Man Clause?
A Key Man Clause is a contractual protection given to the investor. It allows the investor to not make any fresh investments in an entity if one or more key men are not available to run the same due to any reason whatsoever. A key man is a critical resource, whose presence is essential to the operation of the entity and in whose absence the entity would not be able to function smoothly. A Key man clause typically puts all new investments on hold till the replacement of the key man is finalized and operational.
Typically, a Key Man Clause is used by investors putting their money in investment funds like private equity, a venture capital firm, a hedge fund, or a mutual fund. Start-ups may also use the Key Man Clause to create a sense of security and assurance among their investors.
Why is a Key Man Clause Important?
Huge amount of money is at stake: Investment firms handle a huge amount of money, which is typically infused by the investors. These investors expect the investment firm to use the money wisely. Hence, you can find Key Man Clauses being used widely by investment firms.
Guarantee of efficiency: A Key Man Clause also operates as a guarantee of efficiency to investors. Investors would be assured that they would not be required to infuse fresh funds in an entity, till an efficient key man who has all the requisite abilities, skills and experience is found as a replacement.
Prerequisite of engaging an investment firm: Sometimes, investors use Key Man Clauses as a prerequisite of engaging an investment firm.
How are Key Man Clauses Drafted?
A well-drafted Key Man Clause should contain:
A list of all the key personnel who have the required skills, ability and experience to qualify as 'Key Men’ of the entity and without whom the operation of the entity would not be possible.
Events triggering the Key Man Clause: A list of all possible events which may trigger the Key Man Clause should be identified and mentioned. For instance, exit of the Key person, ceasing of his employment with the company for any reason whatsoever, death, arrest, disability, ceasing of his participation in the daily affairs of the company etc.
If there is more than one Key Man, then the clause should also provide that upon the exit of how many Key Men shall the clause be triggered.
An efficient procedure for replacement should also be provided in the Key Man Clause.
Sometimes, the triggering of the Key Man Clause also leads to termination of the agreement. For instance, “Party A would be at liberty to terminate this agreement, if XYZ, the Key Person, as identified under this agreement, ceases to participate in the daily business of the company or exits the company for any reason whatsoever”.
The Key Man Clause also imposes a requirement of intimation or information, the moment a Key Man Clause is triggered.
How are Key Man Clauses Implemented?
There are various steps to the implementation of a Key Man Clause. These steps are:
Creation of the Key Man Clause: Drafting an efficient and holistic Key Man Clause with all parameters clearly captured is essential to its implementation. For this purpose, make sure to identify who are the Key Men of your entity.
Key Man Insurance: Typically, a small entity who may not be able to speedily replace their Key Men, should buy Key Man Insurance, which would compensate them in the event one or more Key Men cease to work with the entity for any reason whatsoever.
Replacement Plan: The final step in the implementation of a Key Man Clause is the replacement plan. Typically, a Key Man Clause enables the investors to hold off new investments till a replacement is found. Hence, it becomes all the more important to have an efficient replacement plan with fixed timelines in place.
To summarize, a Key Man Clause should ideally be included in an agreement with an investment firm. It provides contractual protection and helps in smooth transition without any unnecessary risk being incurred on the huge amounts of investment at stake and hence, inspires investor confidence.