Good leaver or bad leaver? When and why it matters

Good leaver/Bad leaver provisions are typically found in shareholder agreements, employee share schemes, investment agreements and/or the company’s articles of association.

Carrot and Stick

Their purpose is partly to provide an incentive to shareholders who work in the business (i.e. employees, including directors) to work hard and receive a share in the growth of the business when leaving and cashing-in (Good leaver) but also to deter a shareholder who is important to the business from leaving before an agreed date or being guilty of some misconduct which might damage the business, usually in breach of contractual obligation (Bad leaver).

Shareholder Agreements

The focus of this note is on shareholder agreements. It is often the case that the definition of Good leaver in shareholder agreements will include an employee and shareholder of a company who:

• dies, or
• becomes incapacitated through physical or mental illness; or
• is made redundant; or
• voluntarily retires from employment after a pre-agreed period of time;

In the first 3 examples this is an involuntary event that brings an end to their contract of employment and triggers a Good Leaver event. Sometimes provision is made for the directors to exercise their discretion to declare a leaver to be a Good leaver and so provides flexibility.

Having defined what constitutes a Good leaver it is often the case that any other event of departure from the company is a Bad Leaver event and this makes sure all events are covered between the 2 definitions so a Bad leaver event might include:

• leaving voluntarily (other than retiring) to work elsewhere before expiry of a pre-agreed period of time; or
• dismissal for gross misconduct or
• dismissal which is not constructive or unfair

In many cases such triggering events are extended and can involve very complex drafting to accommodate what the parties are prepared to agree. Whatever is agreed, it is very important that the drafting is clear and unambiguous in order to avoid any dispute over interpretation. As you can imagine this can be, and often is, a fairly contentious area that requires great care and proper legal advice.

Value of Shares on Exit

Good leaver/Bad leaver provisions are relevant because they regulate the “exit price” i.e. the price the exiting shareholder will receive for his share. As you might expect, it is normally the case that the drafting will usually result in a Bad leaver receiving less for his shares than a Good leaver. The price is therefore heavily weighted in favour of a Good Leaver (e.g. full open market value of his shares) and heavily discounted for a Bad Leaver.

You might ask if the level of discount for a Bad Leaver might be seen as unfair and probably not legally binding in law because it might be a penalty. Well, in a recent case (Moxon v Litchfield) the High Court judge confirmed that well-drafted good leaver/bad leaver provisions are enforceable. The court decided that although the consequences of enforcing the bad leaver provisions were quite harsh there were no grounds to intervene.

As with much case law much turns on the facts of the particular case.

Interrelation between employment and shareholding

A shareholders’ agreement is a contract made between shareholders. A contact of employment is made between an employee and his employer (the company). The two are mutually exclusive; an employee has no right of recourse against his employer if he is in dispute with his co-shareholders. Similarly, a shareholder has no right of recourse with his co-shareholders if he is in dispute with his employer (the company).

However, it is important to note that well drafted shareholders’ agreements will also require well drafted contracts of employment. This is because a shareholders agreement will normally trigger a bad leaver event where the shareholder (being also an employee) ceases to be an employee of the company. The reason being, in the majority of cases, that the shareholders all set out to ensure that they are all pulling their weight and doing what is required of them (as set out in contracts of employment), in order to share in their collective efforts by reference to increase in the value of the company and their shares. If a shareholder is in breach of his contract of employment, there is no reason why he should continue to take any benefit in the increase in the company’s value at the expense of his co-shareholders.

Watch out for Traps

Be wary that a shareholder whose contract of employment is terminated will be entitled to an exit price for his shares as stipulated in his shareholders’ agreement but he might also be entitled to claim compensation for breach of his employment contact and/or compensation for unfair dismissal.

Additionally, a shareholders agreement should have robust provision for buying out the exiting shareholder’s shares. Great care should be taken to ensure that the shareholders agreement does not include provisions that create a binding contract on his co-shareholders to purchase his shares. Such an obligation could have disastrous tax consequences for the exiting shareholder.

Get Advice

These are just a couple of traps to be aware of and the safest bet is to ensure to take professional advice. Shareholders agreement are quite complicated structures and need to be properly thought through and balanced for which professional and experienced guidance should be sought.

Both Sess Sigre and Valerie Findlay contributed to this article. Get in touch with either Sess or Valerie to see how we can help you.