As your business grows, you may find that an increasing number of people own part of your company. You may have given equity to investors such as private equity or venture capitalists in return for their financing. Or, you may have put an employee incentive scheme in place. Offering employees shares or options 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 one of these shareholders to leave, whether that be an employee that resigns, or an investor who wants their money back? You need to figure out, up-front, how these leavers will be treated. After all, that leaver might be you.
In this article we take a look at leaver provisions, why it’s important to understand them, and how they work.
- What are leaver provisions?
- Where will I find leaver provisions?
- How do leaver provisions work in fundraising and company sales?
- Leaver provisions in employee share schemes
- Examples of ‘good’ and ‘bad’ leavers
- How are shares valued on exit?
- The mechanics of a share transfer
- How important is it to negotiate leaver provisions in fundraising or acquisitions?
- Leaver provisions and other agreements
What are leaver provisions?
Leaver provision in share incentive schemes
These leaver provisions are designed to deal with the situation when someone leaves your employment. 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 in fundraising
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.
Leaver provisions in company sales
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.
Where will I find leaver provisions?
You’ll find leaver provisions in many kinds of transactions. Here are some examples:
- Venture capital deals
- Private equity buy-outs
- Option and employee incentive schemes
- Sale and purchase agreements in a merger or acquisition
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.
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 post-investment 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’. This is to motivate staff to perform well post-investment.
- You sell your company, and the buyers want you to stay on for a period of time post-sale so that you can pass on your knowledge and expertise. This is called an ‘earn-out’.
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:
- If someone leaves the company for reasons that aren’t 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 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.
Examples of ‘good’ and ‘bad’ leavers
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:
- 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. 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.
The mechanics of a share transfer
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:
- 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 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.
How important is it to negotiate leaver provisions in fundraising or acquisitions?
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.
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 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.