Dealing with shares held by ex-staff
Shares held by ex-employees or directors cannot be compulsorily acquired unless the articles and or shareholders’ agreement has created the concept of automatic or implied consent. If you rely on the standard articles downloaded when the company was set up you will be in difficulty as they do not come with automatic or implied consent.
Drawing on our experience of advising private companies and their shareholders over many years we explain what can be done to protect the other shareholders when staff leave.
When staff leave what happens to their shares?
Problem area where directors/employees hold shares – no automatic good and bad leaver provisions
What happens if an employee or director who is also a shareholder leaves the company?
The answer is – that employee or director remains a shareholder, with dividend and voting rights, and ultimately, any gain on the share sale. Just because employment or directorship ends does not mean that share ownership ends. Without agreement – directors and employees will continue as shareholders as they are .not obliged to sell their shares on termination of directorship or employment.
Model articles – problem emerges when often too late
Most start-ups know it costs about £20 to incorporate a company online at Companies House. For this, the start-up gets model articles of association. These articles work splendidly when everyone gets on. Unfortunately, that is the only time they work. They do not describe what happens when shareholders leave employment.
Ex staff can block a company sale
Shareholders, divorced from a company’s daily work create an administrative burden. These shareholders must be included in any shareholder meeting. Potentially, such shareholders can block any vote requiring 75% approval, i.e. a special resolution. Ex-employee shareholders can paralyse company decision making process. They might even block a company sale.
Share rights for founders or investors can be different from the share rights for others. For example, good and bad leaver provisions do not have to apply equally to all shareholders. Other rights which can be included or excluded include the right to dividend, the rate of dividend paid, voting rights and rights to capital.
Good and bad leaver clauses
It is quite common to deal with director or employee shareholders differently when it comes to cessation of employment.
Good leaver provisions
Good leaver provisions could cover where the employee or director ceases to be employed because of:
• Ill health;
• Resignation after a certain number of years of service.
Recommendation – set out a definition of good leavers
We recommended the shareholders’ agreement sets out the definition of good leavers and deals with who is a bad leaver. The benefit of being a good leaver is that the ex-employee or director gets preferential treatment over bad leavers. Often good leaver shareholders are required to sell their shares on termination of employment but at “fair value”. We have set out some ideas for how to deal with fair value below.
“Bad leavers” are typically those who:
• Breach the terms of their service or shareholders’ agreement;
• Resign after a short period of employment.
The idea is a bad leaver does not receive fair value on termination of employment or directorship. Instead, bad leaver shareholders often must sell their shares to the company at the higher of:
• Par value, i.e. the share’s face value;
• The price paid for the shares.
Employers can reserve the right to decide whether an ex-employee or ex-director is a good or bad leaver.
Funding the acquisition of shares on leaving
What if the company or remaining shareholders lack the cash to purchase the shares at the time that an employee or director leaves?
One tip is to anticipate that funding for the purchase of shares could be difficult. We suggest that the shareholders’ agreement includes the flexibility for the remaining shareholders to elect to:
• Permit the company to buy back and cancel the shares if it has distributable reserves; or
• Allow the leaver to continue holding the shares until either the company or shareholders are able to fund the purchase; and in the meantime;
• Remove voting, dividend and veto rights.
You need to make sure that the leaving director or employee cannot block any business decisions until the company finds sufficient funds to buy them out.
For listed companies, by definition, there is a market price for the shares. For private company shares there is no market price. Often the shareholder’s agreement will outline a solution, to avoid costly disputes.
How to determine fair value?
In practice it is difficult to pre-determine the fair value of the shares at the date of award base on some unknown point of transfer in the future. The most common solution is therefore to pre-determine who decides an appropriate share price, if the shares are bought out. That person could be:
1. The company’s existing accountant;
2. A third party independent accountant, if a shareholder feels the company accountant might be biased; or
3. If the parties still don’t agree, then the Institute of Chartered Accountants of England & Wales.
How is fair value calculated
Many shareholders’ agreements are prescriptive and set out the valuation formula to be adopted in dealing with a good leaver’s shares. Typical approaches include asset based valuations or EBITDA and often a combination of both. Depending upon the business, specific add backs and deductions can be specified.
Bad leaver shares – avoiding a penalty
Buying back a leaver’s shares at par value might constitute a penalty. In brief, an agreement should not include provisions that are penalising a party over and beyond the loss that might have been suffered. Compulsory transfers at par value mean that the leaver is kept from its property (shares) or required to sell it for undervalue. This could be a penalty, even if the shareholder’s agreement or articles allow this valuation. Therefore, it is more common to set the bad leaver share price at the higher of par value or the price paid to acquire the shares.
When considering leavers provisions care should be given to the commercial context, whether the sanction is proportionate given the bargaining position of the parties.
It is not easy working out what is best and what is achievable when staff who hold shares leave. We have experience in working with either the shareholder who is leaving/left left employment or the company and its remaining shareholders. Finding a solution is what we achieve. Please do get in touch on 020 7438 1060, we are happy to provide a scope and fee estimate.