Navigating employee good and bad leaver clauses

Navigating employee good and bad leaver clauses

Navigating employee good and bad leaver clauses

Employee good and bad leaver clauses are important for companies with employee share ownership. They encourage employee retention, safeguard shareholders’ and company interests and ensure a smooth transition if an employee shareholder leaves.

In this blog, we will look at the purpose behind these clauses and the key elements to be considered when drafting them.

Purpose of employee share ownership

The principal purpose of employee share ownership is, by allowing employees to have an ownership stake in the business, to incentivise employees to work hard and contribute to the growth in value of their employer.

On the other hand, should an employee leave, the leaver should not benefit from the further growth in value of the company. This will also disincentivise the employees who remain with the business, whose efforts would otherwise reward the individual who has left and is no longer contributing.

Good and bad leaver clauses

Good and bad leaver clauses are a mechanism under which the company can require the departed employee to sell and transfer shares back to the company or to other shareholders.

They are relevant to both:

● allotted shares, being shares which have already been issued and are registered in the names of employees

● employee share options. The option terms will commonly have good and bad leaver provisions, so that an employee who leaves is restricted in exercising options after leaving. If the option terms permit exercise of options prior to an exit, the allotted and issued shares resulting from the option exercise will need to be covered by good and bad leaver clauses in the company’s Articles of Association.

A distinction is usually made between a leaver who is a good leaver and one who is a bad leaver. This recognises that an individual may cease to be employed:

● as a good leaver – in circumstances which are not the fault of, or a consequence of the voluntary actions of, the employee (death, wrongful dismissal)

● as a bad leaver – where the employee leaves as a consequence of the employee’s own actions (dismissal for cause, voluntary resignation)

This categorisation is then usually reflected in the price the leaver will receive for their shares under the good and bad leaver clauses.

Key elements

Good and bad leaver clauses are usually documented in the company’s Articles of Association and possibly also in the Shareholders Agreement.

The essential elements are:

1. Defining a Good Leaver and a Bad Leaver

Definitions to establish:

Employee ShareholderAn employee or possibly also a consultant who holds shares Include the possibility of the individual being employed or engaged by a subsidiary of the company
Consider whether the provisions should apply equally to the founders of the company who are employed or whether they have separate good and bad leaver provisions
LeaverAn employee shareholder who ceases to be employed or engaged Often the definition will also include an individual who serves notice of termination of their employment, so that the leaver provisions apply at that point rather than on the expiry date of their notice period
Good LeaverSpecify good leaver events, which typically include:
– death
– incapacity
– redundancy
– unfair, wrongful or constructive dismissal
Bad LeaverOften this definition will be any leaver is not a good leaver. This prevents the possibility of an individual being neither a good leaver or a bad leaver. Bad Leaver events would then usually include:
– dismissal for cause or gross misconduct
– voluntary resignation

2. Deemed service of a transfer notice

A leaver will be treated as being deemed to have served a transfer notice in respect of their shares at the point at which they become a leaver.

Consider:

– whether the provisions should apply equally to all of the leaver’s shares, especially in the case of a founder. A founder may be permitted to retain part of their shareholding or may receive fair or market value for all or part of their shareholding in circumstances where non-founder employees would only receive nominal value; and

– whether the shareholders or board can waive the leaver requirements

Deemed service of a transfer notice will then trigger the process under which the shares will be available for purchase by specified classes of people, which may include:

– the company itself (though any purchase by company will need to comply with legal requirements for purchase of own shares, in particular the availability of distributable profits)

– an employee share ownership trust

– one or more individuals selected by the Board/Shareholders (either existing or new employees)

– all shareholders in proportion to their shareholdings

Beware of unintended tax implications if employees acquire shares at less than market value – this could give rise to income tax and national insurance contributions becoming payable by both the employee and potentially the company.

3. Transfer price

The price at which the shares are offered for purchase depends on whether the leaver is a good or a bad leaver.

Good LeaverMarket value or fair value One issue to be determined is whether a discount should be applied to reflect the leaver’s shareholding being a minority interest
Bad LeaverLower of (i) market or fair value and (ii) the issue price for the shares or nominal value

If the price is by reference to market value or fair value, this will need to be established. Often, this is either agreed between the company and the leaver or, in the absence of agreement within a period of time, determined by either the company’s accountants or an independent accountant under an expert determination process.

4. Payment

The mechanism should specify when the leaver will be paid for their shares. If a good leaver and the price is determined as market or fair value, a deferred payment process or payment by instalments may be appropriate.

Consider also whether the company will be able to buyback shares in light of the Companies Act 2006 rules which determine a company own share purchase and in particular whether the company has sufficient distributable profits.

Note that stamp duty will be payable on any share transfer or a company share buyback.

5. Deferred Shares

As an alternative to shares being either bought back by the company or purchased by new or existing shareholders, good and bad leaver clauses can also include provision for the leaver’s shares to be converted into deferred shares (with no voting or economic rights), with the ability of the company to buyback these deferred shares and cancel them in the future.

About the author

Jonathan Dawe is an experienced corporate and commercial lawyer, with over 30 years’ experience advising clients on corporate transactions and matters.

Paper Rock templates

Paper Rock’s selection of template shareholders agreements and related articles of association contain good and bad leaver provisions, with clear explanatory guidance on the potential alternatives. We also have standalone good and bad leaver wording for inclusion in a company’s Articles of Association.

Each template is available for immediate download as a single purchase or as part of a subscription and is accompanied by a clear explanatory guidance note. For more details, visit Investing in a Company.

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