Employee shareholders who are no longer employees

Shares held by a leaver cannot generally be compulsorily acquired unless the company’s articles of association and/or shareholders’ agreement provide for this. If a company has only adopted standard articles, it may not be able to force a transfer of the shares, meaning the leaver remains a shareholder.

Drawing on our experience of advising private companies and their shareholders, we explain how appropriate provisions can help prevent a former employee or director who is no longer actively involved in the business from retaining shares against the company’s wishes.

Let’s begin by considering the problems this can cause.

Shareholders who are no longer involved in a company’s day-to-day operations can create an administrative burden. They must still be included in shareholder meetings and, depending on their shareholding, may be able to block decisions requiring 75% approval, such as a special resolution. Former employee shareholders may therefore complicate decision-making or even prevent a company sale.

There are several ways to reduce the risk of problems arising where a leaver retains shares.

Amending the articles

With sufficient shareholder approval, it may be possible to amend the articles to introduce compulsory transfer provisions. A special resolution generally requires approval by at least 75% of the votes cast. If the leaver has a sizeable shareholding and support from other shareholders, obtaining the necessary approval may be difficult.

Changing rights attached to shares

Different share classes can carry different rights. For example, good and bad leaver provisions do not have to apply equally to all shareholders. Other rights that may be varied include dividend entitlements, voting rights and rights to capital, subject to the company’s constitutional documents and applicable law.

Good and bad leaver clauses

Many companies amend their standard articles to include compulsory transfer provisions. These often impose different requirements depending on whether the leaver is classified as a “good leaver” or a “bad leaver”.

Good leaver provisions

Good leaver provisions may cover circumstances in which an employee or director ceases to be employed because of:

• Ill health;
• Redundancy; or
• Resignation after a specified period of service.

Recommendation - set out a definition of good leavers

We recommend that the shareholders’ agreement defines good leavers and specifies who will be treated as a bad leaver. Good leavers may receive more favourable treatment than bad leavers. They may still be required to sell their shares when their employment or directorship ends, but at “fair value”. We explain valuation options below.

Bad leavers

Bad leavers are typically those who:

• Breach the terms of their service agreement or shareholders’ agreement; or
• Resign after a short period of employment.

Bad leaver provisions may require shares to be transferred at a discount to fair value. The transfer price might, for example, be the lower of:

• Nominal value (the share’s face value); or
• The price originally paid for the shares.

The appropriate mechanism will depend on the agreed terms and the circumstances. The criteria for classifying a leaver should be clearly defined rather than left entirely to the employer’s discretion.

Express rights for company  to buy back and cancel shares

What happens if the company or remaining shareholders do not have sufficient funds to purchase the shares when an employee or director leaves?

A shareholders’ agreement can provide flexibility for the remaining shareholders to consider options such as:

• A company buyback, where the statutory requirements are met and sufficient funds are available;
• A transfer to the remaining shareholders; or
• Deferred purchase arrangements, allowing the leaver to retain the shares until the company or remaining shareholders can fund the purchase.

Any proposal to restrict voting, dividend or veto rights while a transfer is pending must be properly provided for in the relevant documents and comply with applicable law. Such rights cannot simply be removed because the company wishes to buy out the leaver.

Fair value

Listed companies have a quoted market price for their shares. Private company shares do not have a readily available market price, so the shareholders’ agreement should ideally include a mechanism for determining value and reducing the risk of disputes.

How to determine fair value?

It is difficult to specify the fair value of shares at the date they are awarded when the transfer may take place years later. A common approach is to agree in advance who will determine the value if the shares are to be bought out. This could be:

1. The company’s existing accountant;
2. An independent accountant, particularly where the company’s accountant may be perceived as biased; or
3. An independent expert appointed under an agreed procedure, which could involve the Institute of Chartered Accountants in England and Wales.

How is fair value calculated?

Shareholders’ agreements may prescribe the valuation method for a good leaver’s shares. Common approaches include asset-based valuations and EBITDA multiples, or a combination of the two. Depending on the business, the agreement can also specify adjustments, add-backs and deductions.

Co-ordinate the share transfer documentation with signing the settlement agreement

If the company’s articles and shareholders’ agreement do not provide an effective mechanism for compulsory transfer, a practical option may be to agree the share transfer alongside an employment settlement agreement. This requires the relevant parties’ consent and appropriate documentation.

It can be difficult to determine the right approach when a leaver retains shares and may influence company decisions. We have experience advising both companies and leavers and can help you assess the available options. Please contact us on 020 7438 1060 for a scope of work and fee estimate.