Leaver provisions: what constitutes a “Good” or a “Bad” Leaver ?

Founders – the original shareholders of a company – are the driving force behind the company’s success as they contribute their skills and knowledge to expand the business. As the company grows, attracting new investment and talent, the founders’ ownership of the controlling stake in the company may not be reflective of their contribution at that new stage of development and sometimes deters the company’s growth. That’s when leaver provisions (typically found in shareholders’ agreements and articles of association) come into play. Such provisions specify when and how the founders’ shares could be transferred back to the company or sold to the remaining shareholders. 

 

Since retaining top talent is of paramount importance, leaver provisions could also be structured to apply to directors and senior managers of the company, who were issued shares (often at a discount to market value but not below the shares’ nominal value: see section 580 Companies Act 2006) to incentivise and reward them for their service. In addition to shareholders’ agreements, leaver provisions applicable to directors and employees of the company are further described in share option rules, employment contracts and directors’ services agreements. 

 

In the context of both founders and senior management, leaver provisions serve as an extra layer of protection to investors who are keen to ensure that the key personnel stay with the company for a specific period of time. If they do not hold up their end of the bargain, it is deemed fair that they lose some or all of their equity.  

 

Good leaver vs bad leaver

The distinction between a good leaver and a bad leaver is important. Generally, a good leaver is entitled to keep a certain percentage of their shares and/or to obtain a fair value for their shares. Normally, a bad leaver is obliged to transfer all of their shares at a heavily discounted price. In other words, this is inherently a contentious topic and therefore it is crucial to clearly define the terms in the relevant agreements and, where applicable, the articles of association.  

 

The term good leaver is often used in relation to persons who leave the company due to:

• retirement
• incapacity
• death 
• redundancy
• unfair dismissal 

 

The shareholders’ agreement could also define a good leaver as a shareholder who leaves the company for whatever reason after a certain period of time (typically at least two years).

In contrast, the term bad leaver is used in relation to persons who leave for reasons such as:

• fraud
• dismissal for gross misconduct
• breach of the shareholders’ agreement
• disqualification from being a director 
• departure before the agreed term

 

Remember, good and bad leavers are not statutory terms, and so you are free to use whichever classifications you see fit when developing your shareholders’ agreements, share option rules or other contractual documentation. It may also be a good idea to grant a certain level of discretion to the board of directors to relax the criteria and to designate a leaver as a good leaver, if they believe it is fair to do so.

 

Compulsory share transfers

Once a shareholder is classified as a good or bad leaver, what happens next depends on the procedure set out in your articles of association, shareholders’ agreement or other contractual documentation. Typically, your shareholders’ agreement would set out compulsory share transfer rules applicable to both good and bad leavers and would state that all leavers are required to sell their shares back to the company or to other shareholders. The company – and the remaining shareholders – normally have the option but not the obligation to buy the shares of a departing shareholder.

 

For the company and its members, a compulsory transfer is advantageous because the leaver’s shares become immediately available for distribution to new talent or investors without the need to issue additional shares and dilute the existing shareholders ownership. 

 

Share valuation

Whether the leaver is categorised as a good leaver or a bad leaver is significant because it impacts the value of their shares following departure. On the one hand, a good leaver will usually be paid market price (sometimes referred to as “fair price”) for their shares. A bad leaver, on the other hand, can be required to transfer their shares at nominal value or at a discount to the current valuation. Transfer at a nominal value can be justified because a discount may not always be sufficient to compensate the company for the loss incurred as a result of a bad leaver’s departure. However, the parties should ensure that the measures are not punitive, otherwise the relevant provision may be held unenforceable.

 

Compulsory share transfers are almost always controversial, since departing shareholders may not necessarily wish to give up their equity upon leaving their post. It is therefore important to agree on the events that trigger the compulsory transfer procedure as well as the details of the transfer itself. This includes what percentage of the leaver’s equity will be subject to the compulsory transfer provisions and the price at which the leaver’s shares are deemed to have been offered for sale. Careful drafting is required to ensure that there is no ambiguity about the procedures or definitions when a key person leaves and to incentivise them to put their best efforts into the company. 

 

Our insights, articles and guides do not, and are not intended to, constitute legal advice or be an exhaustive review of all legal developments. Although every effort is made to ensure that the information provided in this article is accurate as of the publication date, please be aware that this is area of law may be subject to change. Please seek legal advice before applying the information provided to any specific circumstances, transactions or legal issues.