Article
8 mins read
Updated on 6 May 2022
Our subject expert
Jas Bhogal
Partner - Corporate
As your business expands, it's common for a diverse group of individuals, from investors to employees, to hold equity in your company. While offering shares or options is an excellent way to incentivise growth and reward staff, it raises a critical question: what happens when one of these shareholders decides to leave?
This article is for business owners, founders, and HR professionals navigating the complexities of shareholder departures. You'll delve into leaver provisions, understanding why they are essential to define upfront, how they operate in share incentive schemes, fundraising, and company sales, and where to find them within your legal documents.
Defining clear leaver provisions is crucial for protecting your business's interests, maintaining stability, and ensuring fair treatment for all parties involved in a shareholder's exit. To ensure your leaver provisions are robust and align with your business goals, it is advisable to seek expert legal advice from funding round lawyers, and we're here to help.
These leaver provisions are designed to deal with the situation when someone leaves your employment. Leavers are categorised as either being:
In a funding scenario, the principal purpose of leaving provisions is to put the equity of the founders at risk if they leave the company, or if the company doesn’t perform as forecast during the pitch to investors. Because investors have established their valuation and invested based on the founders’ commitment to the business, it’s deemed fair that the founders lose some of their equity if they bail early.
Similar to investors, someone who buys your company expecting you to stay with it for a period of time, post-sale, won’t be happy if you don’t fulfil your part of the deal. Leaver provisions in company sales are designed to deter founders who play a vital role in the business from leaving before a certain date. 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 individual’s departure? And what about situations such as redundancy or constructive dismissal of an employee?
Understanding how leaver provisions work is crucial for any entrepreneur that’s serious about growing their business.
You’ll find leaver provisions in many kinds of transactions. Here are some examples:
Leaver provisions may be relevant any time you have staff members, directors or even outsiders such as consultants providing services to your company.
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 share scheme agreements, founders agreements and in term sheets.
Note that certain Shariah or Islamic laws may be relevant in the context of a leaver, and you need to draft them carefully so that they’re not deemed ‘confiscatory’ should these laws apply to your transaction or one of your parties.
Leaver provisions are relevant in fundraising and company sales in the following kinds of situation:
Because vesting can be complex to understand, and what’s ‘market’ can fluctuate, you may be tempted to ignore them or leave them up to others to negotiate them. If you’re a founder, this is a mistake. It’s really important to make sure your leaver provisions work for you.
Typical leaver provisions look like this:
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 for staying on, it can be counterproductive if employees feel they can’t leave because they’d sacrifice share ownership and are therefore trapped, as this can work against the business’s interest. For that reason, make sure you draft them carefully, and take advice.
Leaver provisions are particularly important when issuing growth shares, as these are typically offered to executives who are crucial to the company’s success.
Deciding what constitutes a good or bad leaver can be extremely tricky, particularly since you’ll be drafting provisions in advance of the actual event. Here are some potential scenarios, and what category they’re likely to fall into:
Bad leavers are normally those that damage the company in some way, or cause losses, for example:
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.
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. They may be allowed to keep the shares that have vested, because these represent their contribution to date.
Bad leavers, on the other hand, 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.
How shares are transferred back to the company 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:
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 them. You’ll need to consider this upfront, possibly providing for staggered payment terms to avoid cash-flow issues. This can also provide a disincentive for a leaver to exit, as they won’t be paid immediately for their shares.
In short, very.
If you’re an investor who’s providing large amounts of cash to a business on the basis of the personality or particular skills of the founders, you won’t want them to leave yet continue to profit from an increase in value of the company as a shareholder, particularly if they’re now working for a competitor.
On the other hand, if you’re a founder, the hard work you’ve put into the company to date, and any sacrifices you’ve made in terms of salary, will be represented by the value of the equity you hold. Whatever the reason for your leaving, you’ll naturally be reluctant to give up your shares or receive less than 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.
Whenever you draft leaver provisions, you have to consider the potential effect on other agreements. The terms of a shareholders agreement must not 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.
About our expert
Partner - Corporate
Jas is a corporate partner who helps start-ups, high-growth businesses and investors navigate fundraising, investment and the corporate issues that arise as businesses scale.
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