As your business grows, you may find that an increasing number of people have a slice of the pie when it comes to the ownership of shares in your company. Along with you and your fellow founders, investors such as private equity or venture capitalists will probably want equity in return for their financing. And offering your employees shares or options in your company is a great way to reward them. Not only are these more cash-efficient than bonuses, but they help incentivise your staff to grow your business. But what happens when it’s time for a shareholder to leave your company? Whether you’re considering a fundraising or designing a share scheme, it’s extremely important to work out how leavers will be treated. After all, that leaver might be you.
In this article and video explainer from corporate solicitor, Jas Bhogal, we take a look at good leaver provisions and bad leaver provisions, why it’s important to understand them, and how they work.
The importance of leaver provisions: an overview
Find out more about leaver provisions from corporate solicitor, Jas Bhogal, which give some protection for investors in the way that shares are held by company founders and employees.
What are leaver provisions?
Leaver provisions typically describe what will happen when someone stops being a company employee. Leavers are categorised as either being ‘good’ – the person leaves because their time of an employment has naturally come to an end, or ‘bad’ – they leave because they’ve behaved in such a way that they’re asked to leave.
Leaver provisions are also found in fundraising and company sales. Investors and purchasers may want founders to remain invested in the business for a period of time after the fundraising or sale so that they help it grow (and thus increase the value of their shares). These provisions also work to deter shareholders who play a vital role in the business from leaving before a certain date. If someone leaves before an agreed period of time (and are thus a ‘bad leaver’), they may be asked to forfeit their shares so that they don’t continue to profit from the business after they’ve jumped ship.
So far, so simple. But what happens if there’s a debate about the reasons for an employee’s departure? And what about situations such as redundancy or constructive dismissal?
Understanding how leaver provisions work is crucial for any entrepreneur that’s serious about growing their business.
Where will I find leaver provisions?
You’ll normally find leaver provisions either in the company’ Articles of Association or in a shareholders agreement. You can also find them in employee incentive agreements, founders agreements and in term sheets.
How do leaver provisions work in fundraising and company sales?
Leaver provisions are relevant in fundraising and company sales in the following kinds of situation:
- New investors come on board, and they want to incentivise the founders to stay with the company for a period of time because their contribution to company growth is crucial. If they leave early, there’s a cost attached.
- Investors want a ‘vesting schedule’ in which employees’ entitlement to new shares in the company is subject to milestones – when a milestone is reached, their shares ‘vest’. What happens if someone leaves in the middle of the vesting schedule?
- You sell your company, and the buyers want you to stay with the company as an employee for a period of time so that you can pass on your knowledge and expertise. This is called an ‘earn-out’. What happens if you want (or have to) leave early?
Because vesting can be complex, it may be tempting if you’re negotiating a term sheet for investment or a potential purchase to neglect them or fail to negotiate them fully. However, if you’re a company founder, it’s really important to get leaver provisions right.
Typical leaver provisions look like this:
- If someone leaves the company for reasons that are not their fault (they die, become disabled, or they’re unfairly dismissed), then they’re classified as a good leaver.
- If someone leaves because they’ve done something wrong (fraud, gross misconduct, or breach of confidentiality for example), they’re classified as a bad leaver.
Leaver provisions in employee share schemes
The reason for offering employees shares or options in your company is to reward and motivate them. However, if you decide to set up a share scheme, you’ll need to decide what to do if someone leaves under a cloud, or just because they want to move on.
While it’s important to use shares as an incentive, you have to balance this with making sure that employees don’t feel they can’t leave because they’d sacrifice share ownership, and therefore feel trapped. This might work as a disincentive and work against you, as a company founder. For that reason, it’s important when you set up a share scheme to make sure the leaver provisions are carefully drafted.
Leaver provisions are particularly important when issuing growth shares, as these are typically offered to executives who are crucial to the company’s success.
Examples of ‘good’ and ‘bad’ leavers
Deciding who’s a good or bad leaver can be extremely tricky, particularly as these have to be drafted and negotiated well in advance of the actual event giving rise to the exit. Here are some potential scenarios, and what category they’re likely to fall into:
- Death or serious mental or physical condition that means the person can’t continue working
- The death or ill-health of an employee’s spouse or child
- Retirement because the person’s reached retirement age
- Unfair dismissal by the company
- Failure to meet performance targets for reason beyond that person’s control (COVID-19 for example)
- Voluntary resignation if this is for good reason, for example the investors or founders feel that they have already contributed substantially to the company’s success
Bad leavers are normally those that damage the company in some way, or cause losses, for example:
- Dismissal for gross misconduct
- Failure to meet performance targets because of poor performance
- Voluntary resignation if the founders or investors don’t want that person to leave
- Departure before an agreed milestone
- Disqualification as a director
- Breach of a shareholders’ agreement
Because it can be tricky to decide whether a leaver is actually good or bad, sometimes a shareholders or share scheme agreement will provide that the board of directors has discretion to decide the issue.
How are shares valued on exit?
As you can imagine, how shares will be valued on exit can be a contentious issue. For this reason, putting the time in up-front to considering various scenarios, and taking good legal advice is crucial.
Good leavers will normally be asked to return their shares to the company and will be paid market price for them. It’s also possible that they be allowed to keep the shares that have vested, because these represent the value they have already brought to the company.
Bad leavers where there has been an element of misconduct or in a venture capital scenario where that person is crucial to the company’s success, are often asked to return their shares to the company at nominal value (£1 per share for example).
Sometimes the price offered for the shares will be at some discount to the market value, depending on the circumstances, by way of penalty.
Invariably there will be discussion about how a market valuation should be arrived at. It could be pegged to share value at the last investment round. In the context of an employee share scheme, you could ask your accountant or auditor to provide a market valuation.
The mechanics of share transfer
Shares that are transferred back to the company may be dealt with in a number of ways, and this is usually described in the Articles. The shares may be bought back by the company, transferred to a pool of shares offered to other employees, or the other shareholders may be allowed to buy them. This is a matter for negotiation.
Being able to acquire a leaver’s shares is advantageous to the company because:
- Executives will have an incentive to stay on with the company until their shares fully vest.
- Leaver’s shares can be made available to a new joiner rather than having to issue new shares and dilute other shareholders.
- It’s not a good idea to have an ex-employee who’s left under a cloud to remain a shareholder and benefit in the company’s growth.
In the case of a company acquisition, if the founder decides to leave early in a ‘good leaver’ situation, it may be that the vesting schedule will be accelerated so that their shares vest early. Given that it’s not their fault, they should be rewarded as originally planned when the company was sold and the earn-out agreed.
When someone leaves and they are entitled to be paid for their shares, the existing shareholders will have to find the money to pay for the shares, either because they buy them themselves, or the company buys them. Either way, you’ll need to think about how to deal with this when you draft your leaver provisions, possibly providing for staggered payment terms to avoid cash-flow issue. This can also provide a disincentive for a leaver to exit, as they won’t be paid immediately for their shares.
How important is it to negotiate leaver provisions in fundraising or acquisitions?
Leaver provisions are very important to professional investors and other shareholders. Because large sums are being provided to a company, often on the basis of the personality or particular skills of the founders, investors won’t want these individuals who may have left because a disagreement has arisen (and who may now be working for a competitor), to continue to profit from an increase in value of the company.
On the other hand, if you’re a founder, you may have contributed a great deal to the early success of the company without necessarily having been paid for your hard work. Instead, your early sacrifice is represented by the value of the equity you hold. Whatever the reason for your leaving, you shouldn’t be required to give up your shares or not receive full market value for them.
Although it can be time-consuming to negotiate leaver provisions, consider this as a good investment in guaranteeing the business’s success, particularly in the context of a share scheme.
Leaver provisions and other agreements
Whenever you draft leaver provisions, you have to consider the potential effect on other agreements. The terms of a shareholders’ agreement mustn’t conflict with the terms of the Articles for example, and employment agreements and directors’ service contracts should also be aligned. If you’re a founder and shareholder, you should also make sure that you have an employment agreement and that its terms reflect any leaver provisions you have agreed with investors.