Good leaver/bad leaver clauses set out terms of transfer of all or some of the shares of a departing director-shareholder to the remaining ones based on the reason for departure.
If a founder is also employed as a director of the company, he or she has employment rights, which are quite separate to shareholder rights. Good leaver/bad leaver clauses provide a mechanism to tie the end of employment with the end of share ownership.
Good leaver clauses provide incentives to founders who are important to the business to stay working in it until milestones are reached, while bad leaver clauses act as a deterrent to leaving early or breaching another contract (such as a director’s service agreement).
Defining what a good or a bad leaver is
Leavers of both types can be defined by actions as broadly or as narrowly as the shareholders like, with one being the remainder of actions that the other isn’t. Typically, actions that would define a good leaver would be:
- mental or physical incapacity that doesn’t allow the founder to continue working
- departure following change in the remuneration, duties or role of the founder as an employee
- the achievement of a particular event
Other shareholders may also be able to agree that a leaver is a good one at their discretion.
Retirement may also be an action, but since there is no longer a default retirement age, retirement as an action may be discriminatory against other non-departing shareholders.
A bad leaver may have acted in such a way as to damage the business – with evidence of loss likely to be already apparent. The definition of a bad leaver might be tied to actions such as:
- dismissal from employment for gross misconduct or any other reason that is not unfair or constructive
- exceeding limits of authority
- disqualification as a director
- breach of the shareholders’ agreement
- failure to achieve certain targets before voluntarily leaving employment
A bad leaver clause may seek to penalise the founder for his or her actions, by forcing the sale of his or her shares at a discount to the current valuation. All shareholders should be aware that this may not be sufficient to compensate others for losses as a result of the actions of the departing shareholder, and that it may not be possible to pursue the leaver for further damages. In other words, these type of clauses do not provide insurance.
There may be several types of bad leaver, with different rules associated with each. The provisions don’t have to be as black and white as “good” or “bad”. Bad leavers are often named as “early” leavers in order to remove the negative connotations of leaving under what are perfectly reasonable circumstances.
Having multiple types of leaver does complicate arrangements.
Share valuations on departure
The price at which the shares are bought in any situation is a commercial matter, not a legal one.
Generally, good leavers will be bought out at fair market value, and bad leavers will have their shares bought at a discounted valuation. The price will be calculated as at the date of termination of employment.
A discounted price is effectively a penalty. A court may decide that a price is too punitive, unfair, and therefore is unenforceable. Recent cases suggest that if a bad leaver provision is clearly commercial in nature (and not personal), and has been negotiated by all shareholders (and not imposed), it is enforceable.
Valuation of a private company is always difficult because it is subjective. The adage that something is worth what someone else will pay doesn’t work in leaver situations.
So shareholders need to agree on how the company will be valued under different scenarios. For example:
- a particular valuation method or formula might be used
- an independent accountant may be asked to provide an opinion
A bad leaver may receive:
- the determined value of his or her discounted (which may vary depending on the circumstances of departure)
- the nominal value of the shares
- the lower of the two
As well as price, payment can be delayed so as to allow money to be found to buy the shares, and provide an incentive for the terms not to be triggered.
The question of who buys the shares also needs to be considered. Shareholders might not have cash to hand to pay for shares on the unexpected departure of a co-owner. Nor might the company. But the company may be able to arrange loans for a purchase more easily than individuals.
Payment might be delayed until another event is achieved (such as an IPO). However, shareholders need to be careful to make sure that this event will happen within a reasonable timeframe, otherwise such a delay could be deemed unfair.
Options to buy rather than requirements to buy
Because finding the money to buy out the leaver can be difficult, instead of the obligation to buy out, other shareholders could be given the right instead. In other words, other shareholders have the option to buy in certain circumstances, but do not have to exercise that option if they are not able to do so.
Options may also be more tax efficient for certain shareholders.
The need to consider leaver provisions alongside other documents
Shareholders need to make sure other documents do not conflict with the terms in the shareholders agreement. Leaver provisions may conflict with terms in directors service agreements (employment contracts), the articles of association, lending agreements where the directors are personally guarantors, and share option agreements.
Employment law is important to consider. A claim that a founder cannot carry out his duties as a director may be well founded, but employment law may require you to offer alternative suitable employment, rather than having him or her leave. You want to avoid claims for compensation for unfair dismissal or breach of contract.
It is important in any case that the terms are clear in order to avoid argument over meaning. Forced sale of shares, at any price – even a fair one, is likely to be contested, and litigation is expensive.
Should you include leaver clauses?
The argument for including leaver clauses is that other shareholders, particularly institutional ones such as venture capital firms, will not want founders who have left the business (who may now be working for a competitor, or who may have been dismissed as a director) to continue benefitting from holding shares, and to continue owning rights.
Depending on your view, this may not be a particularly strong argument.
A founder is likely to have put a lot of work into the business to get it to where it is. Share ownership is often regarded as a reward for risk taking. Business risks in a small start-up could be argued to be greater than once the company is established, and therefore keeping hold of shares is fair compensation for those earlier risks.
Additionally, a former director with experience of the business may be as likely to be able to contribute positively to shareholder decisions as any current director or intuitional investor.
The reason institutional investors like good leaver/bad leaver clauses is that they provide a mechanism to remove control from someone who no longer is a requirement in building the business. It may appear to be a cynical view that investors don’t want to cede power to anyone (let alone someone who doesn’t have any future role in increasing the investment’s value), but such a tactic is a commercially sound one.
Because a new investor will insist on having a new shareholders agreement written up, including good leaver/bad leaver clauses in an agreement between founders is probably unnecessary.