Good leaver and bad leaver explained

Good and bad leaver clauses

Many companies amend their standard articles to include compulsory transfer provisions, often with different rules and share valuations depending on whether a departing shareholder is considered a "good leaver" or "bad leaver".

Company and commercial is a core area of practice for us. We can help you by ensuring you have the right clarity on good or bad shareholder leavers. We also very regularly deal with disputes relating to a bad shareholder leaver.

Why are good leaver and bad leaver clauses important?

To protect shareholders, many companies amend their articles of association and/or include good leaver and bad leaver provisions in a shareholders agreement. These provisions can be important in a number of situations, including:

• Preserving value for the remaining shareholders - by requiring a director or employee shareholder who leaves the business to transfer their shares.
• Where share options are being granted - many high-growth businesses use employee incentive arrangements. Defining what constitutes a good or bad leaver for share options that have not yet been exercised, or have already been exercised, is important. Should unexercised options lapse if the leaver is a bad leaver? Should the terms of the option change? There is no single right approach, but in our experience, a lack of clarity can lead to disputes, particularly where the options have significant value.
• Where you have a bonus scheme - clarity around what constitutes a good or bad leaver can also be important when determining entitlement to bonuses.
• Company law doesn't force a departing employee or director to sell shares -  without good and bad leaver clauses, they will continue to own their shares and are not compelled to transfer them. The shares will retain the same value as all other shares of the same class. Good and bad leaver provisions need to be expressly incorporated into the company's articles or included in a shareholders' agreement.

The concept of a bad leaver is intended to cover situations, often where the shareholder is also an employee, where they cease to be employed in circumstances that have damaged the company, or where shares or options were obtained on advantageous terms based on an agreed future contribution to the company which has not been fulfilled.

What to include in good or bad leaver clauses?

There are no fixed requirements as to how good and bad leaver clauses must be drafted. Typical considerations include:

• What constitutes a bad leaver? - these may include where directors or employees have been dismissed for fraud or gross misconduct, or fail to meet performance targets .
• Compulsory transfer of shares - the consequences of being a bad leaver will usually include being required to transfer shares, potentially without payment or at a reduced value.
•  What constitutes a good leaver? - this will usually include directors or employees who cease to be employed due to circumstances such as redundancy, ill health, resignation or where the employee has performed well but simply wants to move on to another job opportunity.
• How shares will be valued - The distinction between good and bad leavers is usually centred on the value the leaver receives for the shares they must transfer on exit. There are various ways of valuing leaver shares. The mechanism does not need to be set out in the articles, but clarity in a shareholder' agreement or company articles will reduce the scope for dispute.
• What is the trigger point for good or bad leaver clauses to apply? - this will usually be when the employee shareholder ceases to be employed. This provisions in the articles dealing with good and bad leavers should dovetail with the employment contract.
• Dispute resolution - auditors, accountants and/or specialist share valuation experts can be asked to determine the value of shares where the directors and leaving shareholder cannot agree. Valuing shares in a private company where there is no proposed sale of the entire company can be inherently difficult and speculative. There is no requirement to have an independent valuation.

What happens to the shares where a leaver has to sell?

Revised company articles of association should set out who will be offered the shares and who has the right of first refusal. You also need to consider what happens if no shareholder wants to acquire the leaver’s shares. In practice, there are a number of options.

It is good practice, to provide flexibility, to include in the articles or shareholders’ agreement express permission for the company to buy back and cancel the shares.

Practical implications where shares are transferred

There are compliance requirements associated with the forced transfer of good and bad leaver shares.

• the transfer of shares will need to be reported at Companies House.
• for larger shareholdings, a PSC statement may be needed for the remaining shareholders.
• depending upon the value paid for the shares, there may be tax to report and pay.
• for most employees and directors, the transfer will need to be reported on the annual employment related securities (ERS) return.

Disputes involving bad leaver shares

It is necessary to consider the provisions under the employment agreement and the articles. Claims under the employment agreement are separate to claims under the articles. The legal position in any bad leaver dispute will need to take into account the employment agreement, articles, shareholders' agreement and any option agreement.

Can employment claims include loss of share rights due to being a bad leaver?

Employment law claims are ultimately decided in the Employment Tribunal in most cases. Employment Tribunals are generally reluctant to become involved in disputes arising from shares or options where these matters fall outside their jurisdiction. Accordingly, it is rare in practice for compensation ordered by an Employment Tribunal to include loss of share rights and/or loss of share option rights.

How do bad leaver clauses impact share options?

The good and bad leaver provisions in option agreements given to employees or directors are important as they usually trigger the lapse of the option if the employee or director ceases to be employed. Once the option lapses, the employee or director cannot exercise the option and acquire shares, and therefore does not become a shareholder.

The terms of lapse can vary between good and bad leavers. The option agreements will often expressly provide that the option cannot be exercised if the option holder is no longer employed. Many option agreements also reserve discretion to the directors to permit exercise where the holder is a good leaver.

A share option agreement, employment contract, company articles and shareholders' agreement all create different rights and obligations, so it is important that these documents work together.