April 27, 2022
Building and scaling a business takes a tribe, from founders, to employees, to third party partners. Naturally, many companies issue shares or share options to attract and reward the key individuals who have made an impact on the business and to help keep them incentivised. However, what happens when an employee shareholder leaves the business?
Shares and share options cannot be compulsorily bought back or lost unless the relevant consents have been mapped out in the company’s articles, investment agreement or share option plan. Therefore, it’s crucial that the board and it's investors think carefully about how leavers will be treated. This can be a tricky negotiation point as there isn’t a one size fits all approach. Fortunately for you, we’ve taken the time to explain what you should be thinking about when it comes to good leavers versus bad leavers. In need of information on shareholders' agreements before you start? Check out our shareholders' agreements checklist here.
Leaver provisions are the price of doing business from an investor’s point of view and founders should expect to be signing up to these provisions in addition to other key employee shareholders when receiving investment into the company. Founders should always approach this on the basis that these provisions could take effect against them in the future. That is why it is important to bear in mind market standards and not try to punish leavers. These provisions should not be viewed as “golden handcuffs”; making it difficult for an employee to walk away from the company, but rather a protective measure to retain value in the business.
From the company’s perspective, it’s unlikely to be acceptable for leavers to always exit the business with their shares and/or options intact. This may mean the employee is taking potentially valuable equity with them and possibly benefitting from future growth that they did not help create. What if they are guilty of gross misconduct or fraud? Allowing someone who has harmed the business to join in its success later would be a bitter pill to swallow. Makes sense, right?
However, there will be occasions when it makes sense to allow an employee to retain their shareholding, for example, if the end of their employment was out of their own control.
On the one hand, it may be tempting to simply ask for all the employee shares to be transferred back to the company on exit or to have share options cancelled. However, depending on the circumstances of the employee’s departure, this seems slightly unfair particularly if the individual has added real value to the business. This is where good leaver and bad leaver provisions can be extremely helpful. Under these types of provisions, the leaver is categorised as either “good” or “bad.” Simple stuff. At the point of the employee’s exit, the company(usually the board of directors) will decide whether the circumstances of the employee’s departure are for good reasons or for bad. Typically, a leaver is defined as “good” if they exit the company for reasons such as unfair dismissal, ill health, redundancy or death. These are sometimes thought of as “no fault reasons.” A person is usually categorised as a “bad”leaver if they act fraudulently or behave in a way which would allow the company to terminate their employment contract. However, it is common for these provisions to be drafted quite flexibly to ultimately give the board discretion as to which definition will apply.
Good leavers are usually permitted to:
In the former scenario, what’s known as “reverse vesting”, is a good way of establishing how many shares/options a leaver can retain. This is a common feature in leaver provisions. Reverse vesting provides that a leaver only has a certain number of shares or options “at risk” at any onetime. Therefore, should that individual leave the company during an agreed period of vesting (e.g. 3-4 years), the proportion of shares/options that may be lost if the employee leaves during this period, decreases on a monthly basis. This lets the individual keep the number of shares/options that have been earned over the period and can also incentivise them to remain with the company whilst the business is going through crucial growth stages.
As part of this vesting, it is usual to build in what is known as a “cliff”, which is the minimum period an employee must remain with the company before the vesting begins - typically, a cliff of 12 months is agreed. No shares will vest during the first 12 months but at the end of this period, the whole year’s shares vests at once and then the rest of the shares vest on a monthly basis for the remainder of the period.
Departing employees are also usually allowed to keep shares that they have purchased as part of investment rounds, where the price paid was the same as a third party investor. Any retained shares are usually subject to other conditions, such as loss of voting and/or pre-emption rights.
If it is agreed that a shareholder can sell some or all of their shareholding when they leave, the key question is “for how much?” Valuation of shares can also be a big sticking point. Often, good leavers will receive “fair value” for their shares (i.e. market value). This can either be agreed between the parties or calculated by an accountant if there is a disagreement regarding the valuation.
The position is slightly different with bad leavers. Bad leavers are not usually permitted to retain any of their shares or options. Often, a bad leaver will be asked to transfer their shareholding back to the company for no consideration at all or at face value. Alternatively, the leaver provisions may set out that the shareholding will convert into “deferred” shares on the employee’s termination date. Deferred shares have no voting rights or rights to profit or capital and are therefore deemed “worthless” to the holder. With regard to share options, these are stated to lapse on an employee’s termination date.
Leaver provisions are often negotiated as part of the investment process and therefore can crop up in both the investment agreement and the articles of association of the company. In a share scheme context, the leaver provisions can be found across the scheme rules and individual share option agreements.
Remember the company’s articles of association are a public document so it’s best to keep any confidential provisions in the investment agreement if the company doesn’t want the world to know about them!
As you can see, there is plenty to say on leaver provisions. Most employee exits will need to be dealt with on a case-by-case basis as there are lots of variables to be considered. Whilst there are many standard approaches, it’s important that founders and investors think carefully about how to approach the drafting now to avoid any complicated and stressful conversations at a later date.