When do Founders become Employees?

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A start up  tech Company instructed Gannons when one of its founding directors attempted to bring a claim for constructive unfair dismissal. This claim couldn’t succeed unless the Outgoing Director had been an employee for more than two years. The Company asserted its directors had only recently become employees following the execution of directors’ service agreements. The Outgoing Director claimed he had been an employee ever since he had begun receiving remuneration from the Company, a much earlier date which would bring him over the crucial two year threshold needed to claim unfair dismissal and resultant compensation.

Question

The Employment Tribunal had to determine whether the founding directors had become employees of the Company before entering into their directors’ service agreements. In this instance, the Tribunal decided that the directors had not.

Overview

Three partners founded a data management company in August 2012.  They held all of the company’s shares between them, with the Outgoing Director holding 40%. At first they fitted their work for the Company around other commitments, and did not earn any remuneration until 2014. In April 2014 the Outgoing Director began to work for the Company full time, and the directors began to grant themselves regular shareholder dividends as well as paying themselves £833 a month through payroll (a tax efficient arrangement which allowed them to take full advantage of their personal allowances). In September 2017 the directors entered into directors’ service agreements and received a market rate salary operated via PAYE.  The Company took a corporation tax deduction for payroll expenses.

When is there an employment contract?

An employee is someone who works under a contract of employment. While this contract is usually written, it is possible for a contract of employment verbal and  inferred from the conduct of the parties. When a matter comes before the Employment Tribunal there is no burden on the party denying employment to prove the lack of a contract. Rather, it falls to the putative employee to prove such an arrangement exists, and doing so requires more than simply providing documentation. In deciding whether a contract of employment exists, the Employment Tribunal will consider:

Written evidence

The most obvious example being a contract of employment. However, evidence of an employment relationship could also come from board minutes or a memorandum of understanding which defines the relationship between the putative employee and employer. In our case a 2013 board minute actually indicated that there was no employment relationship prior to 2017, as the founding directors opted not to enter into a service agreement until the Company had become more established. This meant that, at the time the Outgoing Director resigned, he lacked the two continuous years of service required to bring a claim unfair or constructive dismissal.

How the putative employee is paid

In our case the founding directors were paid a comparatively small sum through the company payroll and received the rest of their remuneration in the form of shareholder dividends. This is a common arrangement in newer companies, as it allows directors to take full advantage of their personal allowances, but it is not a typical feature of an employment contract. Where a director receives no wage, or a comparatively small wage compared to the value of their work, it suggests that they are not an employee.

Whether the parties conduct themselves as if bound by a contract

For an employment contract to exist, the putative employee must be under the control of the putative employer. If a director is required to work regular hours, needs to work in a specified place, is allocated specific holidays or is subject to restrictive covenants it is likely that they are an employee. Conversely, where a director sets their own hours and working arrangements, and is entitled to take unlimited holidays while still receiving their remuneration (as is the case with shareholder dividends) it is likely that they are not an employee.

Conclusions

At the Employment Tribunal the judge took the view that no one would pay an employee £833 per month and therefore the sacked director could not have been an employee at all times.  It was held that it was not until the director started to receive a commercial rate of pay at the time of signing up to the service agreement that he accrued employment rights as an employee.

The result was the former director employee did not have the requisite period of employment to claim unfair dismissal or constructive dismissal.  If the claim had been successful the award could have been in excess of £80,000.

The Employment Tribunal refused to deal with the position on whether he was a bad leaver for the purposes of the prevailing shareholders agreement.   The judge took the usual approach of deeming the shares to be separate from the employment contract and determine the Employment Tribunal does not have jurisdiction to look into matters relating to shareholdings.

Even if the employee had been successful it is a moot point as to whether any claim for unfair/constructive dismissal would take into account dividends as they are not “earnings”.

  • In your case the situation may be very different. Determining when and if a founder has become an employee requires consideration of all the circumstances. This is an evaluation with which Gannons would be happy to assist.  Please do call us on 0207 438 1060 for help.