How a Startup Can Offer a Severance Package

by Jennifer Kiesewetter in

TLDR

  • Although it’s an unenviable task, most employers — including startup founders — will have to terminate someone at some point. One way to soften the blow of termination is to offer a severance package.
  • However, before you decide whether your startup should implement a severance package, you should understand what they are, who is eligible, how they impact unemployment benefits, and how it’s taxed.
  • Severance is a package of pay and/or benefits offered by the employer to certain terminated employees. Generally, providing severance is entirely voluntary, based on the goodwill of the employer.
  • Typically, determining who is eligible for severance benefits is up to the startup’s discretion. However, one federal law does mandate severance.
  • Under the Worker Adjustment and Retraining Notification (WARN) Act, you’ll need to provide severance pay to those terminated employees if your startup meets certain guidelines.
  • If you include a severance agreement or in your employee handbook, you are legally bound to follow those written terms and provisions, even though providing severance is generally voluntary.   
  • You may include a waiver in your severance package, essentially stating that in exchange for the severance pay and/or benefits, the employee waives any right to sue you, your partners, or your startup.
  • In some states, severance pay impacts unemployment benefits.

For most employers, letting an employee go is one of the hardest things you'll have to do as a startup founder. Although it’s an unenviable task, most employers will have to terminate someone at some point.

An employee may not be a good cultural fit. Or, perhaps, you need to terminate them through no fault of their own, such as a mass layoff. Or, maybe you need to lay employees off because of economic reasons, such as those caused by the recent pandemic. Terminating employees, unfortunately, is part of doing business.

One way to soften the blow of termination is to offer a severance package. However, before you decide whether your startup should implement severance packages, you should understand what they are, who is eligible, how they impact unemployment benefits, and how they're taxed. In this article, we’ll explore the ins and outs of providing severance to terminated employees.

Severance Definition

Severance is a package of pay and/or benefits offered by the employer to certain terminated employees. Generally, providing severance is entirely voluntary, based on the goodwill of the employer. Except for specific exceptions, addressed later in this article, although federal law addresses how an employer should pay a terminated employee their final wages, federal law does not address severance.

Let’s break down severance packages into pay and benefits, looking at examples for each. For pay, founders can offer 14 days to two or more weeks of pay, based on the terminated employee's hourly wages or salary. As another option, you can also base the severance on how many years the employee worked for your startup plus the 14 days to two or more months.

For example, suppose an employee worked at your startup for three years. Their most recent salary was $75,000. In that case, you would use the following equation:

3 x ($75,000) / (52 weeks) x (4 weeks) =  $17,307.69

Additionally, you can develop other formulas for severance pay, such as one week of pay for every year worked for your startup. This provision of cash can help employees transfer to a new position or to unemployment benefits.

If you’d like, you can also provide benefits as part of severance in addition to pay. Benefits could include:

  • Unused sick time
  • Health insurance benefits (e.g., COBRA continuation coverage with the employer paying the premiums on behalf of the employee)
  • Stock options
  • Retirement benefits
  • Outplacement services
  • Loan forgiveness
  • References
  • Any other benefits you think may be appropriate

Who Is Eligible?

Typically, determining who is eligible for severance benefits is up to the startup’s discretion. However, one federal law does mandate severance. Under the Worker Adjustment and Retraining Notification (WARN) Act, you’ll need to provide severance pay to those terminated employees if your startup has more than 100 employees, if you plan to lay off a large percentage of your employees, and if you fail to give them notice of the termination 60 or more days in advance. The WARN Act does not govern how much severance you should provide or if you should include both pay and benefits. That is still up to the startup even when the WARN Act applies.

However, when deciding on your severance package, you should familiarize yourself with both federal and applicable state employment laws, governing discrimination, health plan continuation, and employee benefits governance. Hiring an attorney familiar with state and federal employment laws can help you design a compliant severance program.

Severance Protocol When a Startup Employee Leaves

As addressed above, when determining what’s in your severance package, you should understand applicable state and federal laws, such as the WARN Act. However, it would be best if you also state your severance package in writing, through policies and procedures as well as through a severance agreement with the employee who is being terminated.

However, once the severance package is in writing through a severance agreement or in your employee handbook, you are legally bound to follow those written terms and policies, even though providing severance is generally voluntary.   

If you create a severance policy as part of your employee handbook, not only are you legally bound to follow those provisions, but it’s also best to share it with your employees. They should understand when they might receive severance and how it is calculated. If you are terminating an employee, you should present the severance agreement formally, allowing them time to review it with their own attorney.

Additionally, in certain instances, you must provide the employee with a set amount of time to consider the severance offer under federal law. For example, if an employee is over 40, you must give them 21 days to review the agreement.  Also, if that employee was part of a more significant layoff, you are required to provide them with 45 days to review the agreement. Finally, that employee may revoke their signing of the agreement for up to seven days after execution. Because of all of these ins and outs, it’s best to have an attorney help you draft the severance agreement, making sure all salient points are appropriately covered.

Once the employee signs the severance agreement, accepting the package, then you will pay them all monies owed in a lump sum while processing all benefits according to your internal processes and applicable laws. If you agreed to pay your employee in installments, then you’ll set those payments up, providing the first payment as agreed.

Remember, part of the benefit of severance packages is to give the employee some financial breathing room while they look for another job or apply for unemployment benefits. Making agreed-upon payments to terminated employees as soon as possible is best.

Finally, you may include a waiver in your severance package, essentially stating that in exchange for the severance pay and/or benefits, the employee waives any right to sue you, your partners, or your startup. This waiver of legal rights must be “knowing and voluntary,” and startups are highly encouraged to hire an attorney to draft this waiver. 

How Does Severance Impact Unemployment Benefits?

In some states, severance pay impacts unemployment benefits by either lowering the employee’s unemployment benefit amount or delaying the receipt of these benefits. In other states, severance pay does not affect the amount or timing of unemployment benefits. Your applicable state law will provide more details on this impact, allowing you to communicate this to your employees.

Let’s look at a couple of examples. Since severance is commonly paid in a lump sum, terminated employees will be able to apply for unemployment benefits immediately in most states. However, suppose employees are paid their severance in installment payments. In that case, the employee may not apply for unemployment benefits until all installment payments are received, depending on the state. Note that when employees voluntarily leave a company, they are typically not eligible for severance or unemployment benefits.

Severance Tax

Severance, like regular wages, is subject to two types of taxation: withholding and employment tax.

Tax withholding is the amount subtracted from your employees’ paychecks to pay federal taxes in addition to any applicable state taxes, depending on where the employee lives and works. The same percentage withheld from an employee’s paycheck would be the same percentage withheld from the severance pay.

Employment taxes include the employee’s Federal Insurance Contributions Act (FICA), going to fund Social Security and Medicare. Social Security taxes total 12.4 percent of pay, with both the employee and employer paying half. Medicare tax equals 2.9 percent of pay, also with both the employee and employer paying half. These same percentages apply as well to severance pay.

How Can Offering Severance Benefit Your Startup?

Offering a severance package can not only lessen the blow when you have to let someone go, but it can also bolster your reputation, even with involuntarily terminated employees. Severance is a great way to help your employees find their next opportunity instead of leaving them financially high and dry. Also, if new talent knows that you offer severance if the job doesn’t work out, you can attract better-qualified candidates to your startup.

If you decide to include a waiver in your severance package, you’re building in legal defense protection for your startup. Since the terminated employee cannot sue you if they waived those rights in exchange for accepting the severance pay and/or benefits, you have eliminated a potential lawsuit from a former employee.

Firing employees is probably not something you’d like to focus on when building your startup. However, if you prepare for this ahead of time, with professional help, you can make these unfortunate events smoother and more pleasant for everyone involved while protecting yourself legally. By showing goodwill to your current and former employees, you demonstrate that you are a fair, compassionate employer, boding well for your startup in both the short and long run.

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