Parachute payments: Overview, definition, and example
What are parachute payments?
Parachute payments are financial arrangements, typically found in employment contracts, where a company provides significant compensation to executives or key employees in the event of a termination, merger, or acquisition. These payments are usually structured as a severance package and are designed to ensure that employees are compensated if they are dismissed or leave the company due to a change in ownership or corporate structure. The goal of parachute payments is to provide financial security for executives, often in the form of a lump sum payment, stock options, bonuses, or other benefits, when their employment is terminated under certain conditions.
For example, an executive might have a contract that guarantees a severance payment worth three years of their salary if the company is acquired and the executive is laid off as part of the acquisition.
Why are parachute payments important?
Parachute payments are important because they offer financial protection to executives and key employees who may lose their jobs as a result of major corporate events such as mergers or acquisitions. These payments can help retain top talent during uncertain times, as they reduce the financial risks associated with corporate restructuring. Additionally, parachute payments are often used as a tool in executive compensation to align the interests of executives with those of shareholders and ensure that executives are incentivized to act in the best interests of the company, especially during significant corporate changes.
Understanding parachute payments through an example
Let’s say a large corporation is acquired by another company, and the CEO of the target company is terminated as part of the acquisition. According to the CEO's contract, they are entitled to parachute payments amounting to a lump sum equal to five years of their salary and additional stock options. These payments ensure that the CEO is financially protected after losing their position due to the acquisition, and the compensation helps smooth the transition for both the executive and the acquiring company.
In another example, a key employee in a startup company negotiates a parachute payment clause into their contract, which provides a significant severance payment if the company is sold and they are laid off as part of the deal. The parachute payment serves as an incentive for the employee to stay with the company and contribute to its growth, knowing they will have financial security if the company is sold.
An example of a parachute payment clause
Here’s how a parachute payment clause might appear in an executive employment agreement:
“In the event of a change of control of the Company, the Executive shall be entitled to a severance payment equal to [Insert amount or number of years of salary] and any unvested stock options shall become immediately vested. This payment will be made if the Executive’s employment is terminated within [Insert time period] following the change of control.”
Conclusion
Parachute payments are a key component of executive compensation packages, designed to provide financial security to top employees during times of corporate change, such as mergers or acquisitions. These payments help mitigate the risk of losing employment due to a change in ownership and can serve as an incentive to retain valuable executives during periods of uncertainty. Understanding parachute payments is essential for both executives negotiating employment contracts and businesses seeking to attract and retain top leadership talent while ensuring fair compensation.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.