How the upcoming changes to the unfair dismissal laws might impact venture capital investing

Paul Callaghan and Howard Palmer, Partners at Winston Taylor, examine how upcoming changes to UK unfair dismissal law could affect venture capital investors and portfolio companies.

The article notes that the introduction of the Employment Rights Act 2025, which is due to come into force from 1 January 2027 has profound implications for the VC ecosystem and could result in overly burdensome unfair dismissal claims being made against firms.

Radical reforms to the unfair dismissal laws in the UK are due to come into force from 1 January 2027 pursuant to the Employment Rights Act 2025. The changes reduce the length of service needed to bring an unfair dismissal claim from 2 years to just 6 months. More significantly, however, the cap on compensation awarded from unfair dismissal, which is currently around £125,000, is being abolished altogether. This has profound implications, as compensation for unfair dismissal is calculated very broadly meaning that, as well as base salary, losses for bonuses, LTIPs and all other benefits, including loss of shares and share options would all be included. In a situation where equity is linked to continued employment then the potential value of an unfair dismissal claim could be significant. The terms of most venture capital investments include vesting of founder shares, so that if a founder is unfairly dismissed and loses all shares, the value of a potential claim could be very significant. The same applies to lucrative share option packages offered to large numbers of employees of venture backed businesses.

For a dismissal to be fair, there needs to be a fair reason. The most common ones are likely to be performance, conduct and a redundancy situation. In the context of venture-backed companies, it is probably most common that there will be performance terminations. Senior employees who are not performing to the required standard may need to be dismissed. However, unless they have had clear performance warnings ticking the required UK legal boxes any dismissal for performance reasons is likely to be unfair. In fact, there is no absolutely safe way to terminate someone for poor performance. It is always open to an employee to allege that either they have performed well, targets that were set were unfair, they have not received reasonable support to achieve their targets or they did not receive any measurable targets at all. It costs an employee nothing to bring an employment tribunal claim. You do not even need to instruct a lawyer. In this age of AI, more and more claimants are bringing claims themselves where they incur no legal fees.

The current common way to deal with poor performers is to have a protected conversation. Poor performers will be offered a few months' pay in return for waiving their rights to bring an unfair dismissal claim. That can be done relatively easily now bearing in mind the unfair dismissal cap. Both sides make a decision as to whether it is worth fighting a claim based on what is offered bearing in mind the size of the compensation cap. With the abolition of the cap from 1 January 2027 the situation changes radically. Protected conversations offering 2-3 months' pay are unlikely to be attractive as soon as an employee takes the legal advice they need to take in order for a settlement agreement to be legally binding. Where equity or other valuable benefits are lost on termination, venture-backed businesses can expect to receive extremely high demand letters from 1 January to include compensation for lost equity.

There is no easy way to prevent these claims. It is critical that performance measurement processes are tightened up, but that does not prevent employees still challenging dismissal. Even a fairly dismissed employee, leaving without a settlement agreement, could bring a claim, potentially for multiples of £millions where equity is lost, and such a claim is likely to take years to run through the employment tribunal process, if not settled. During the period that a significant claim remains unresolved, the portfolio company may struggle to raise further investment due to the risk that the claim is successful. Given the cadence of many funding rounds, this could encourage such behaviours from outgoing employees and may consequently result in ever increasing settlement demands.

The current UK Private Capital model documents contain a clause where founders waive claims against the company in respect of lost equity value as a result of termination of employment, as indeed do many employment contracts and option grants. However, these provisions will no longer be enforceable once these provisions of the ERA come into force.

There is however a potential solution as the law now stands. An employment law provision that was thought to be obsolete allowing employees to have "Employee Shareholder Status" in return for waiving their right to bring an ordinary unfair dismissal claim can provide a solution. An "employee shareholder" is a unique UK employment status and was introduced under the Growth and Infrastructure Act 2013, where individuals traded specific statutory employment rights in exchange for at least £2,000 in fully paid-up company shares. These arrangements were effectively phased out after tax reliefs were withdrawn in late 2016, though legacy agreements remain governed by the Employment Rights Act 1996.

Provided strict statutory conditions are met, the parties may enter into an Employee Shareholder Agreement.

The conditions that must be met are:

1. The terms must be expressively agreed by the parties
2. The employee must have received fully paid-up shares worth at least £2,000 at the time the agreement was entered into
3. There must be no additional consideration provided by the employee
4. The employee must be provided with a written statement setting out certain legislative prescribed matters
5. The employee must have received independent legal advice paid for by the employer
6. There must be a 7-day cooling-off period once the agreement is signed

If all of this happens an employee can no longer bring an ordinary unfair dismissal claim, although they could still bring whistleblowing claims or claims alleging discrimination. This feels like a bold solution but making employee shareholder status a requirement of investment is potentially a current way of avoiding the potential for very expensive unfair dismissal claims further down the line. Needless to say, it is unattractive to those who are required to agree to it – being the very founders and employees that the VCs are looking to back with their investment. Therefore, if competitors are willing to offer deals that do not involve waiving these rights, there is a risk of losing good investment opportunities.

However, employee shareholder status does offer a potential solution. In the meantime, it is vital that any company with current poorly performing senior executives has those executives removed before mid-December to avoid them gaining uncapped compensation rights. Even if they already have 2 years' service, if an employer knows that the person is not going to work out then it is far better to terminate the relationship while the unfair dismissal cap is in place rather than face the potentially extraordinarily high demands for terminations after 1 January.
 

Authored by Paul Callaghan and Howard Palmer at Winston Taylor

The opinions expressed in this article are those of the authors. For more insights from Winston Taylor, visit  Winston Taylor | Transatlantic Law Firm.