Shareholder leavers: the fall out
In start-up companies, founders compete for the best staff. Founders often gift equity to new joiners to attract them. Many start-ups use the model articles that are provided by the government.
This works splendidly while all the parties are getting on well. It is easy to forget about what will happen if everything does not go according to plan. The rights of shareholder leavers upon termination of employment are often overlooked. We see cases where it has been relatively easy to handle the termination of employment. However, with only model articles in place it not so easy to deal with the shares held.
We shed some light for you.
Termination of employment – shareholder leaver problems
The ability to force transfers of shares upon termination of employment only arises if an express agreement has been reached. This is not automatic under the government provisions. We find the problem is most acute with employee or director shareholders. The problem can be compounded if the leaver is a founder as often they have a sizeable shareholding.
Difference between an employment contract and shares
A similar problem does not arise under the employment agreement. This is because even if the employment agreement is silent, or does not exist, there are statutory notice provisions which will kick in. There may be a risk of unfair dismissal(depending upon the circumstances) but ultimately the employer can sever the employment relationship and stop paying.
Similarly, even if the director agreement is silent or does not exist, there is a procedure under the Companies Act for removing directors.
Shareholder holder leavers under model articles
If there are no express provisions, then there will be nothing that the company can do, other than to negotiate a sale of the shares or a company buy back of shares if it can. Sales and company buybacks of shares come with complications. There has to be the money to buyback. And, if the shareholder knows he cannot be forced to sell he may take the opportunity to hold out for what is in reality an over inflated price.
Retention of shareholder rights
In the meantime, the ex-employee or director retains all of his shareholder rights. Shareholder rights include entitlement to dividends, a share of the capital on for example a sale and of practical importance – voting rights. We find voting power creates problems with the running of the business if the leaver choses to be obstinate. And, they often do.
How do you avoid the problem with exiting shareholders? There are some answers which we explain below.
Termination of employment and shareholder leavers – the answers
The solution is to have bespoke corporate documents that cater for shareholder leavers. The documentation does not necessarily have to be complicated. But, it does have to be in place before the shareholder leaves. Documentation provides a framework for avoiding shareholder disputes.
Good leavers and bad leavers
The company needs a shareholders’ agreement that includes the concept of “leavers”. Leavers are typically shareholders who have been directors or employees of a company but have left their respective positions. Leavers can be drafted to mean whatever is needed to suit the parties intentions – there is no restriction on the definition of a leaver.
If the parties in a venture sit down at the outset to discuss this, they can usually agree some fair and reasonable way to deal with “leavers” that everyone is happy with. We see a great number of cases when this discussion has been left for too long. Situations can inflame quickly.
Benefits of a shareholders’ agreement upon termination of employment
A shareholders’ agreement can distinguish between “good leavers” and “bad leavers”. Good leavers can be those who leave the company for reasons of ill health or because the company makes that person redundant. To recognise a prolonged period of sweat equity, the shareholders agreement can also include as good leavers those who choose to resign after a certain number of years.
Design freedom to decide at the time
The idea is that these good leavers may then be allowed to keep their shares or may be required to sell them back to the company. There is flexibility on how any sale price is arrived at. The directors can be left to decide how the shares held by the leaver will be dealt with at the time of leaving. Delaying the decision creates another layer of flexibility as such predictions at the outset are difficult. For total fairness the decision can be left to an independent expert.
Ability to pay shareholder leavers in instalments
There may be circumstances where it is appropriate to stage the payments in instalments. The obligation for the company to pay the installments can be subject to conditions. For example, to protect intellectual property, the company may only be obliged to continue instalments if the seller is not working in competition. Another common condition is the seller’s continued compliance with restrictive covenants.
The termination of employment of a bad shareholder leaver…
“Bad leavers” are often defined as those who resign within a short period of time, or those who breach the terms of their service agreement or the shareholders’ agreement. These bad leavers will then be required to sell their shares back to the company for par value (meaning the face value of the shares), or the price paid for those shares if lower.
Interaction with the employment contract
The law distinguishes between shareholders and employees in companies. Different definitions of leavers can apply in the shareholders’ agreement and directors’ service agreement. Difficulties arise when the terms conflict. The answer is to draft that one agreement takes precedence. This is usually the shareholders’ agreement.
Putting the remaining shareholders in control
If the company or the remaining shareholders do not have the cash to buy the shares of the good leaver, the remaining shareholders can always elect to allow the good leaver to hold onto their shares.
Deals to suit the circumstances may be struck if there is a framework in the first place.
How much to pay the shareholder leaver
If the shareholders are in agreement that if one of them stops working with the company as an employee their shares will be bought back by the company, the question then always arises: “How much”?
Valuing shares in private companies
With listed companies a share price is relatively easy to figure out by looking in the Financial Times, but for unlisted companies there is no open market for those shares.
The parties may be in a better position to pre-agree what price will be paid for those shares early on in the relationship, as opposed to when the relationship is hostile. The aim of a shareholders agreement is to set out a final position that all parties are going to be happy with, whether they are the seller or the buyer.
Who gets the leaver’s shares?
A good shareholders’ agreement sets out who is to be offered the right to acquire the leaver’s shares. There is usually a procedural order, so:
- Shares are first offered to the company.
- If refused by the company, to the largest shareholder. (This does not have to be the case. It is perfectly possible to provide that all shareholders have the opportunity to acquire shares pro-rata to existing shareholdings for example.)
- If the largest shareholder refuses, to the second largest shareholder, and so on.
The skill is in ensuring that all shareholders are happy with the position. A minority shareholder should always look to protect their rights.
Employee shareholders with small percentages of shares
Working out fair value includes deciding if there is to be a discount where the shareholder leaver controls a minority shareholding. Small shareholdings are worth less than large shareholders due to the lack of influence over shareholder voting. Life is clearer if the agreement sets out whether discounts can be applied.