The importance of good leaver and bad leaver clauses

Good leaver or bad leaver shareholders - importance for growth businesses

If you have set up a high growth business, there is a good chance that as you grow, you will need to create (allot) more shares either as part of fundraising or incentivising key staff. A key consideration which is often overlooked is thinking about the circumstances in which those shareholders might exit the business and what should happen to their shares.

This is why having good leaver and bad leaver provisions is a really important way of protecting the business and other shareholders. You will see, from reading on, that a very black and white approach may not always be best and some flexibility may also be important in determining and defining whether an exiting shareholder is penalised.

For good or bad leaver rules to apply, you will either need to change your company articles or include these provisions in a shareholder agreement (or investor agreement). You may also need to include leaver provisions in other key documents such as some of your employment contracts and/or share scheme rules.

Thinking about the many different circumstances in which a shareholder may leave is important at an early stage of your business. We are experienced in advising on all aspects of leaver provisions and can draft up rules either for your articles, shareholder agreement, employee share schemes or other purposes. We are practical and cost effective. Please do get in contact.

The starting point - Compulsory Transfer

Without specific provisions in your company articles of association or shareholder agreement, you cannot compel a shareholder to transfer shares. They can retain shares even if they have acted directly against the company’s interests. For good leaver or bad leaver clauses to become operative, the company’s internal rules must oblige shareholders to transfer shares back to the company or other shareholders under set conditions.

The risk of compulsory transfer rules is that key employees and highly sought after potential recruits will be very nervous of such clauses because they can result in them not accruing the full or any benefit of shares. Consequently, the terms of compulsory transfer rules as well as the triggers for leaving on less than good leaver terms should be carefully considered, perhaps allowing for a degree of flexibility and negotiation with different shareholders.

Advantages of compulsory transfer from the company’s perspective generally include :

• Preventing an employee waiting for valuable shares to vest and then jumping ship to a competitor and retaining the full benefit of shares.
• Shares which are transferred back to the company can be used to incentivise or reward other members of staff.

Good leavers

Defining what will constitute a good leaver is really up to each company. The obvious examples of what most companies will consider to be a good leaver will include where staff are made redundant or have to cease working because of ill health. Length of service may also be a factor.

The classification as a good leaver will often result in the shares being transferred at fair market value, so that will also need to be clearly defined in terms of how that will be calculated.

Bad leavers

As with good leavers, there are no set rules about how a company might designate a bad leaver. The most obvious examples of a bad leaver are where a shareholder has defrauded the company, is dismissed due to misconduct or poor performance, brings the company into disrepute, commits a criminal offence or is made bankrupt.

It is worth considering whether rather than designating a leaver as good or bad, there are many exiting shareholders who may not have been wholly loyal or top performing but who aren’t bad leavers. So, for example if an employee has shares under a share scheme which vested after 2 years, but they then leave 6 months later but do not go to work for a competitor, should they be classified fully as a bad leaver? A very black and white approach could lead to word being spread which reaches individuals you may want to recruit that you are very harsh with employee shareholders and put them off.

The consequences of being a bad leaver can vary considerably. The most common consequence is that the exiting shareholders shares are valued at less than fair market value, with a wide range of possibilities as to what the penalty might be.

Intermediate leavers

For all the reasons given above, it makes sense for businesses to carefully consider not only what will amount a good or bad leaver but also somewhere in between, usually described as an “intermediate leaver”. This category is particularly relevant where a growth business has an employee share scheme  and wants to strike a fair balance and keep it’s reputation as being an attractive business to join.

The most balanced approach to employee share scheme leavers is including reverse vesting. This is where any penalties for leaving are based on timescales and shares at risk of being penalised are generally not all the shares the employee has accrued. The longer the employee stays, typically after a minimum period, often a year, (if the employee leaves during that period he or she may be considered a bad leaver) with the company, the lower the amount of shares which are at risk of being transferred at less than market value.

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