Shareholder leavers: the fall out

In start-up companies, founders compete to attract and retain talented staff. Equity is often offered to new joiners as part of their remuneration package. Many start-ups also adopt the government’s model articles of association.

This arrangement can work well while relationships remain positive. However, it is easy to overlook what happens when circumstances change. The rights of shareholder leavers following termination of employment are often neglected. We see cases where ending the employment relationship is relatively straightforward, but dealing with the shares held by the departing employee or director is far more complicated, particularly where only the model articles are in place.

Potential problem areas with shareholder leavers

• Where the shareholder is an employee – The ability to require an employee to transfer their shares when their employment ends generally depends on appropriate provisions being included in the company’s articles of association, a shareholders’ agreement or another binding agreement. This is not automatically provided for by the model articles. The problem is often most acute where the shareholder is an employee or director, and can be compounded where the departing shareholder is a founder with a substantial shareholding.
• Shareholder leavers under model articles – Without express provisions governing leavers, the company may have no automatic right to require the departing shareholder to transfer their shares. The parties may need to negotiate a sale or consider a company buyback, if legally and financially feasible. Both routes involve complications, including funding and statutory requirements. A shareholder who knows they cannot be forced to sell may also seek a price that the remaining shareholders consider excessive.
• Valuing the shares – For listed companies, the market price can usually be established by reference to published share prices. Private companies have no equivalent public market, making valuation more subjective. It is often preferable to agree a valuation mechanism at the outset, while relationships remain positive, rather than attempt to negotiate a price once a dispute has arisen. A well-drafted shareholders’ agreement should establish a clear process for determining the price payable, taking account of the parties’ agreed commercial position.
• Who gets the leaver’s shares? – A shareholders’ agreement should set out who has the right to acquire a departing shareholder’s shares and the order in which that right can be exercised. For example, the company may be offered the opportunity to acquire the shares first, followed by the largest shareholder and then other shareholders. Alternatively, all shareholders may be given the opportunity to acquire shares in proportion to their existing holdings. The appropriate arrangement depends on the company’s circumstances and the interests of its shareholders. Minority shareholders should consider whether the proposed provisions adequately protect their position.
• Employee shareholders with small shareholdings – Determining a fair price may involve deciding whether a discount should apply to a minority shareholding. A minority interest may be valued differently from a controlling interest, depending on the agreed valuation basis and the circumstances. It is therefore important to establish in advance whether discounts may apply and how the shares will be valued.

Solutions to shareholder leaver risks

The solution is to put bespoke corporate documents in place to address shareholder leavers. The documentation need not be complicated, but it should be agreed before a shareholder leaves or a dispute arises. Clear provisions can provide a framework for managing exits and reducing the risk of shareholder disputes.

• Good leavers and bad leavers – A shareholders’ agreement can include provisions defining different categories of leaver and setting out how their shares will be dealt with. The definitions should reflect the parties’ intentions and the circumstances in which a person may leave. Depending on the agreed terms, a good leaver may be permitted to retain their shares or be required to transfer them, while a bad leaver may be subject to different transfer or valuation provisions. The agreement should also identify who decides how the shares are dealt with and whether any disputed valuation is referred to an independent expert. The appropriate approach depends on the company’s objectives and the balance of protection required by its shareholders.
• Ability to pay shareholder leavers in instalments – In some circumstances, it may be appropriate for the price payable for a departing shareholder’s shares to be paid in instalments. The agreement should specify the payment schedule, any conditions attached to future payments and the consequences of non-payment. For example, continued payments might be linked to compliance with agreed restrictive covenants, provided the relevant conditions are clearly drafted and legally enforceable. Any instalment arrangement must also take account of the legal requirements applying to the proposed transfer or company buyback and the company’s ability to fund the payments.