Good and bad leaver shares

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Once you give away shares you cannot get them back without consent. Consent is not compulsory. This is usually a problem when it comes to ex-employees and directors. The solution is to change the articles to deal with good and bad leaver shares. The pitfall is changes to the articles need to be in place before you award shares.

The key issues with good and bad leaver shares

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. He stops working for the business but he still receives value. Employees are not obliged to sell their shares on termination of 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.

No duty to sell shares when employment ceases

Usually the shareholders are also directors, and sometimes the only employees. These three roles are different. A shareholder owns company shares, whether or not that person is an employee. A majority shareholder vote can remove a director from his employment role. However, there is no implied right to remove a shareholder from a company after he leaves employment.

Ex employees block 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 hold up 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 capital

Share rights for founders or investors can be different from the share rights for others. For example, good and bad leaver shares do not have to be issued 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.

Different types of shares can be a good idea

Different classes of share capital are often referred to as alphabet shares, restricted shares, growth shares or non-preference shares. The concept remains the same. That being different share rights are held by different members of the shareholder population. For example, founder can get A ordinary shares and employees B ordinary shares. The benefit is that the founders protect their position but employees still feel like owners.

Designing good leaver and bad leaver shares

One solution is to add the concept of “good and bad leaver” shares to the shareholders’ agreement. This applies to shareholders who are ex-company directors or ex-employees.

Good leaver shares

Good leaver shares could cover where the employee or director ceases to be employed because of:
• Ill health;
• Redundancy;
• Resignation after a certain number of years of service.

Recommendation – set out a definition of good leaver shares

We recommended the shareholders’ agreement sets out the definition of good leaver shares and deals with who is a bad leaver. It is not necessary to use the same definitions are set out in the employment contract or directors’ service agreement. To avoid confusion, unless there are compelling reasons, we usually suggest the same definitions are used.

  • The benefit of a good leaver share is that the ex-employee or director gets preferential treatment over bad leaver shares. This could be motivational and a “hand cuff” for talented staff hard to find.
  • 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 leaver shares

“Bad leavers” are typically those who:
• Breach the terms of their service or shareholders’ agreement;
• Resign after a short period of employment.

Why have bad leaver shares

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 good leaver 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.

Which allows the former employee shareholder to not block any business decisions until the company finds sufficient funds to buy them out.

Fair value

For listed companies, by definition, there is a market price for the shares. For private company shares there is no market price. The shareholder’s agreement should outline a solution, to avoid costly disputes. Usually, this solution must be agreed early in the shareholder’s relationship.

Sometimes, shareholders pre-agree a price for the shares, be they a buyer or seller. In practice this is difficult. The most common solution is 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.
3. If the parties still don’t agree, then The Law Society of England & Wales, or the Institute of Chartered Accountants of England & Wales.

Good leaver shares – valuation approach

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. It could be a penalty, even if the shareholder’s agreement or articles allow this valuation. There is some debate. 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.

Good and bad leaver shares – silence

A lack of good/bad leaver share provisions means that a departing shareholder can in effect hold the shareholders to ransom if they want to buy the shares. Or, he may not sell them at any price. The ex-employee or ex-director has the upper hand.

HMRC are looking at different share classes with a view to denying entrepreneurs’ relief if new more complex legislation is not satisfied. Therefore if you are hoping to sell shares you should check the latest tax legislation to avoid unexpected tax bills.It makes economic sense.  The risk in not addressing the subject is wasted time and expense later down the line.
Please do get in touch on 020 7438 1060, we are happy to provide a scope and fee estimate.