Good Leavers & Bad Leavers
The battle to attract and retain top talent is fierce for many private (New Zealand) businesses, particularly in the tech sector. As a consequence, an increasing number of companies are offering equity to their key executives. While the desired outcomes are clear, companies need to craft the terms of such offers carefully to avoid pitfalls. In particular, the relevant parties need to consider carefully what should happen to the key executive's shares if he or she leaves the company. This requires some crystal ball-gazing and there are many nuances to consider.
The outcome is generally a series of 'good leaver / bad leaver' provisions, which are effectively carrots for desirable behaviour and sticks for undesirable behaviour. 'Good leaver' provisions incentivise key executives to stay with the company, while 'bad leaver' provisions are designed to deter key executives from leaving the company and/or protect shareholder value from non-performers.
Frequently, it will be agreed that an employee shareholder is obliged to sell his or her shares to the company or other shareholders when he or she leaves the company (and becomes a Leaver).
In some cases, the company (or other shareholders) will have the option to acquire the Leaver's shares, while in other cases the company will be required to acquire the Leaver's shares. Some executives will insist on the latter to avoid potentially being left holding shares in a company in which they are no longer involved. From the company's perspective, it may not be desirable to be contractually required to acquire shares when the timing of that obligation is not within the company's control. This is a matter for negotiation.
Either way, having the ability to compulsorily acquire a Leaver's shares provides various benefits to the company, including:
- Executives are incentivised to remain with the company until shares are fully vested, and ideally until a liquidity event occurs;
- The Leaver's shares become available immediately for a replacement executive, without the need to issue new shares and dilute other shareholders; and
- The remaining management team is not left in the potentially demotivating situation of working to grow the equity position of a former colleague (who may end up at a competitor).
In some cases, a particular executive might be in such a strong position that he or she could negotiate, at the outset, the ability to retain some or all of his/her shares (depending on the timing of their departure and as long as he or she is not a 'Bad Leaver'). There are many possible variations that can be applied in this context, such as the Leaver being entitled to retain an increasing proportion of his or her shares over time (for example, 10% for every year, up to a maximum of 50%), perhaps with any shares that he or she is entitled to retain converting to become non-voting.
In cases where the concept of compulsory transfer is accepted, the debate then shifts to the price at which the Leaver must sell his or her shares.
Pricing on departure
When a Leaver is required to sell his or her shares, common practice is for the price to be determined by reference to the circumstances surrounding the exit. If the Leaver's conduct is in line with expectations (or is at least without 'fault'), then the Leaver will usually be categorised as a Good Leaver and required to sell his/her shares at 'fair value'.
However, if the Leaver's conduct falls short of expectations (or there is a degree of 'fault'), the Leaver will be categorised as a Bad Leaver and required to sell his/her shares:
- at the lesser of 'fair value' and the subscription/acquisition price;
- at a pre-agreed discount to 'fair value';
- in extreme cases where there has been serious culpability on behalf of the Leaver (say, fraud), for a nominal sum (such as $1); or
- in the venture capital context, for a nominal sum (such as $1). This reflects the fact that the success or failure of an early stage company can depend very directly on the retention and engagement of its founder(s).
Despite the clear and logical commercial rationale, questions can arise as to the enforceability of such discounted sale prices, as any discount to 'fair value' could be argued to be an unenforceable penalty (which we will delve into in a future publication).
Also, the tax implications will impacted by the terms on which the shares are issued, the circumstances of any buyback/transfer, and the pricing on issue and on buyback/transfer (which is also beyond the scope of this article).
So who is good and who is bad?
Defining the categories of Good Leaver and Bad Leaver can be challenging, as naturally the exact circumstances of a Leaver's exit won't be known at the outset. In our experience, there are no hard and fast rules and it will depend on the specifics of the transaction and the company.
That said, the various scenarios in which senior executives leave a company generally are treated as follows:
|Leaving scenario||Type of Leaver (for the purposes of clauses relating to the retention and disposal of shares)|
Permanent disability or permanent incapacity through ill health
Permanent disability or permanent incapacity through ill health of the executive's spouse or child
Retirement (at normal retirement age)
Unjustifiable dismissal by the company
Dismissal by the company where the executive has failed to meet certain performance expectations (eg. KPIs)
Generally the most difficult category and will depend on negotiations:
|8||Voluntary resignation by the executive|| |
Will depend on negotiations:
Justifiable dismissal by the company for cause (including fraud or dishonesty)
Departure within an initial minimum period (say 12 months) for any reason whatsoever
Bankruptcy (although this will not always be a separate leaving scenario)
Given the inherent difficulty in defining the Good Leaver and Bad Leaver categories at the outset, it is common for parties to provide the board of the company with discretion to relax the rules and deem a Leaver to be a Good Leaver when they feel it appropriate. This approach can often be used to navigate a sticking point in negotiations. In the venture capital context, often it will be the investor(s) that will have the discretion to relax the rules and deem a Leaver to be a Good Leaver.
Take the time at the outset
Although it can be time-consuming to agree an appropriate set of Good Leaver / Bad Leaver principles, we always encourage parties to consider it an important investment in the long term success of the business structure. Once structured and implemented, the company can then move forward with its key employees aligned and incentivised, safe in the knowledge that a fair and reasonable set of rules will be triggered if and when an executive ultimately leaves the company.
DLA Piper has extensive experience advising both executives and companies in respect of such arrangements. For more information or to discuss any point in greater detail, please contact any of our lawyers below.