Leaver clauses - the good and the bad
Good leaver / bad leaver terms describe the circumstances under which some or all of the shares owned by a leaving director-shareholder (or other shareholding employee) transfer to the remaining owners.
They link staying employed with the financial rewards of owning shares, and leaving employment (whether voluntarily, or on dismissal) with the end of share ownership, and make sure that the exit plans of all shareholders are similar.
Employment rights are separate and different to shareholding rights. Those rights can, to some extent, be combined through use of good leaver / bad leaver clauses.
The idea of a good leaver clause is to reward a key employee for staying employed in the company for a certain amount of time, or until a goal is achieved.
Unlike under incentives such as an option to buy shares, or a clause that vests shares, the person is already a shareholder with the benefits that ownership confers.
The reward is the unconditional continuation of ownership after the occurrence of an event, or retained ownership if the employee leaves the company beforehand but under “good” circumstances.
A bad leaver clause also aims to incentivise an employee from leaving employment, and also from acting in a “bad” way. The incentive is one of loss avoidance – generally a more powerful psychological incentive than reward.
If the employee leaves or is dismissed, he or she forfeits the shares.
A young company is unlikely to be highly valued, yet is likely to have key people employed within it. If the work that the key people do increases the value of the company over time, then the closer to the event that an employee-shareholder leaves, the greater the value at stake to lose by leaving.
A bad leaver clause may penalise the shareholder by forcing a sale at a discount to the current valuation. This may not be sufficient to compensate other shareholders for losses caused by the departing shareholder. Nor may it be possible to pursue the leaver for further damages.
Bad leaver clauses are not an insurance device for other shareholders. They exist to incentivise good behaviour by defining what is bad.
What is good and what is bad?
Good and bad leavers can be defined by events or actions as broadly or as narrowly as the shareholders like. They could be opposites – a good leaver is any non-bad leaver.
There may be several levels of each type of leaver, with different rules associated with each. The descriptions don’t have to be as black and white as “good” or “bad”. Bad leavers are often called early leavers in order to remove any negative connotations of leaving under what are perfectly reasonable circumstances.
The sorts of events and actions that be given in a shareholders agreement as being not bad would include:
- mental or physical incapacity that doesn’t allow the employee to continue working
- departure following change in the remuneration, duties or role as an employee
- the passing of a particular event
It is also common for the decision as to whether the employee is leaving on good grounds to be decided at the discretion of the other shareholders.
Retirement may also be a ground. However, in law there is no longer a default retirement age and an event based on age may be seen by an employment tribunal as discriminatory against other non-departing shareholders.
Bad grounds are most commonly those that damage the business, where evidence of the loss is already apparent.
The definition of a bad leaver might be tied to grounds such as:
- dismissal for gross misconduct or any other reason that is not unfair or constructive
- exceeding limits of authority
- disqualification as a director
- breach of the shareholders’ agreement
- failure to achieve certain targets before voluntarily leaving employment
Share valuation is always subjective. Valuation methods can be worded into a shareholders agreement, but valuations themselves are less likely. If they are, then it is a commercial matter to be agreed upon.
Generally, the shares of good leavers are bought at fair market value, and while those of bad leavers are bought at a discounted valuation. Different valuation methods might be used for each, where one gives a lower price than the other. For example, a good leaver might be bought out at the price of the shares at the last investment round, while a bad leaver might be bought out at the nominal value of the shares. An independent accountant may be asked to provide an opinion on a fair value.
Compulsory purchase at a discounted price is effectively a penalty. If the leaver objects to the price, and takes the shareholders to court, a judge may decide that if the price is too punitive and unfair as a result, it does not have to be enforced. Recent cases lead to a conclusion that if a bad leaver clause is clearly commercial in nature and has been negotiated by all shareholders (and not forced on a minority), it is likely to be reasonable and therefore enforceable.
The event that leads to the departure of one shareholder may come as a surprise to the others. Money may need to be found to buy the shares from the departing person.
A shareholders agreement can include delayed payment terms so as to allow financing to be found. Delayed payment may also act as a secondary incentive not to trigger the terms that would lead to leaving under bad circumstances.
However, shareholders should be careful that payment happens within a reasonable timeframe. A delay could be deemed unfair.
Owners also need to consider who buys the shares. If individual shareholders don’t have the cash, the company could buy back the shares. Even if it does not have cash either, it may be able to arrange for loans more easily.
Another alternative is to provide an option for other shareholders to buy, but not an obligation. If the option is not exercised, the shares could be bought by the company, or sold to an outside investor. Options may also be more tax efficient.
Consider the effect of leaver provisions on other agreements and contracts
Other agreements should not conflict with the leaver terms in the shareholders’ agreement, in particular, directors service agreements, employment contracts, articles of association, loan agreements where the directors are guarantors, and share option agreements.
Employment law should also be considered – although it can change over a period of time.
For example, that a director is not skilled enough to carry out his duties may be a well-founded reason for him not continuing in his post, employment law requires the company to offer an alternative suitable position, rather than having him leave. Dismissing him would likely lead to claims in an employment tribunal for compensation for unfair dismissal or breach of contract.
Is it necessary to use leaver clauses?
The argument for using leaver clauses is that other shareholders, particularly professional investors who invest large sums at an investment round, will not want early-stage employees who have left the business (who may now be working for a competitor, or who may have been dismissed under a cloud) to continue benefitting from holding shares, and to continue holding rights to things such as information about performance.
The converse thought is that share ownership is a reward for risk taking. Business risk may be greater while the company is young (early employees often willingly sacrifice salary to help cash flow) and the reward for that might be equity.
The reason institutional investors often insist on using good leaver/bad leaver clauses is that they provide a mechanism to remove control of the company from someone who no longer key to growing the business. It is not an unsound reason.
For any company without professional investment, these type of clauses are unlikely to be necessary.
Please note that the information provided on this page:
- Does not provide a complete or authoritative statement of the law;
- Does not constitute legal advice by Net Lawman;
- Does not create a contractual relationship;
- Does not form part of any other advice, whether paid or free.
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