The importance of good leaver and bad leaver clauses

A key consideration which can be overlooked by early stage businesses is thinking about the circumstances in which shareholders might exit the business and what should happen to their shares.

The treatment of departing shareholders or employee shareholders in a company can vary significantly depending on whether they are classified as a "good leaver" or "bad leaver". This distinction, typically set out in a company's articles of association or shareholders' agreement, affects not just the financial value a departing shareholder receives but also their ongoing obligations to the business.

Good and bad leaver clauses establish clear rules for what happens if a shareholder leaves due to retirement, death, bankruptcy and other reasons and with employee shareholders, leaver consequences after dismissal or moving to a competitor.

When to think about getting clauses in place

Triggers for implementing good or bad leaver rules typically include :-

• As soon as you set up business - there are good reasons to have leaver clauses in a shareholder agreement right from the time you set up your company

• When you recruit senior employees.

• If your employees are being offered shares or share options.

• If you are seeking new investors and investment.

Leaver clauses can be included either in changes to your company articles, a shareholder agreement (or investor agreement) or other key documents such as some of your employment contracts and/or share scheme rules.

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 have been loyal and hardworking. Common situations include where the employee-shareholder is made redundant or has to cease working because of ill health or death. Length of service may also be a factor.

The classification as a good leaver often results in shares being transferred at fair market value, retention of dividend rights until share purchase, extended period to exercise options (typically 6-12 months) and/or a pro-rated vesting of unvested shares.

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.

Other examples include :-

• Serious breach of directorship duties or fiduciary obligations

• Unauthorised disclosure of confidential information

• Taking clients or key employees in breach of restrictions

• Breaking confidentiality agreements or IP rights

• Working for a direct competitor within restricted geographic area

• Diverting business opportunities from the company

• Resignation before end of specified commitment period (often 2-3 years post-investment)

• Leaving during crucial business phase (like pre-IPO or during investment round)

• Resignation during earn-out period after company sale

• Material breach of employment contract or service agreement

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

There are many exiting shareholders who don;t easily fit the category of bad leaver. 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? Such an approach could feed through to recruitment difficulties.

It often makes sense for businesses to 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.

Compulsory transfer of shares

Without specific provisions in your company articles of association, shareholder agreement or employment contract, you cannot compel a shareholder to transfer shares. They can retain shares even if they have acted directly against the company’s interests. Bad leaver clauses are a way to have the specific right to force transfer of shares back to the company or other shareholders under set conditions.

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.

We can help

We are experienced in advising on all aspects of leaver provisions. We 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.