Good Leavers and Bad Leavers: how can a business handle shares of departing employee shareholders?

When growing a company, individuals that are key to the business are often incentivised by being allotted shares. Whilst the thought of a key employee leaving the business in the future may not seem like an issue at the time of investing, it is crucial that the board and investors think ahead to what happens when they leave and, most importantly, what will happen to their shares.

Leaver provisions are incorporated into investment documents to allow the company and the founders/employee shareholders to agree at the outset on the treatment of the shares of departing employees. Growth companies do not expect leavers to retain all their shares and will usually want to recycle the shares  to incentivise the replacement, while leavers are reluctant to give up their shares and will want to be rewarded for their contribution to the business. For this reason, these provisions are often heavily negotiated, in particular what constitutes a “Good Leaver” and a “Bad Leaver” and the basis on which shares “vest”, such that they can be retained by the leaver.

Who is considered a Bad Leaver or a Good Leaver?

A Bad Leaver is often someone who has resigned (but is not claiming constructive dismissal), acted fraudulently or been dismissed for gross misconduct. A Good Leaver is someone who has ceased to have been employed for reasons such as death, ill health, unfair dismissal, or where the directors have agreed to treat the leaving shareholder as a Good Leaver.

Good Leavers would expect to keep all or some of their shareholding and to receive fair market value for the shares they are required to sell. The mechanism for calculating how many shares the individual would retain and how many are sold is negotiated on a case-by-case basis, but it is common for shares to vest on a monthly basis over three years, so that a leaver would keep all their shares if they leave after three years. By contrast, Bad Leavers tend to be required to transfer all their shareholding for nominal value.

Compulsory transfers: financing a share buyback

If a leaver must transfer their shares, the articles of association often allow the shares to be bought back by the company. The financing of a share buyback and the required documentation are prescribed in the Companies Act 2006 and care is required to ensure compliance.  There are four ways a private company may fund a share buyback:

1. From the company’s distributable profits; however, a growth company is unlikely to have any distributable profits in its early stages so this option may not be available during the first few years.
2. The company could issue new shares and use the proceeds of the issue to finance the buyback, ensuring the allotment of shares is solely for the purpose of funding the buyback. Of course, this gives rise to the question of who the shares will be allotted to and how this might affect the cap table.
3. More uncommonly, the company can buy back the shares out of capital; however, there is a strict procedure to follow under the Companies Act 2006, including the requirement for directors’ declarations of solvency and notices in the Gazette and a national newspaper.
4. Where the aggregate purchase price is the lower of £15,000 and the nominal value of 5% of the company’s fully paid share capital, the de minimis exemption allows for companies that may not have distributable profits to buy back shares out of cash.

Whilst there is no requirement for the articles of association of a company to include a specific authority to allow the company to purchase its own shares, it is important, in particular for growth companies, to ensure that the articles do not restrict or prohibit share buybacks.

To be able to follow the de minimis exemption, the company must also have specific authorisation under its articles, as the absence of a prohibition using cash to finance the buyback is not enough. The Companies Act Model Articles do not provide for the de minimis exemption, so bespoke articles should be adopted. There is nothing in the Companies Act 2006 to suggest that it is not possible to combine the de minimis exemption with other sources of finance, so as to finance the buyback from cash (up to the maximum permitted limit) and the rest from distributable profits.

Employee share scheme

Where a company has an employee share scheme in place and intends to carry out a buyback, it can take advantage of the simplified capital buyback. This process allows for buybacks to take place without the need for the filing of various notices and directors’ statements, but simply having the shareholders approve a special resolution supported by a solvency statement.

Whilst employee exits are generally dealt with on a case-by-case basis as and when they arise, the drafting of the articles of association and investment agreement in relation to leaver provisions and buyback financing options are important if you want to minimise complications at a later date.

If you have any questions on handling the shares of a departing shareholder, please contact Jeremy Davis and Sophie Welbourn.