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The good, the bad and the ugly: a practical guide to negotiating leaver and vesting provisions
How can equity be clawed back when necessary?
Nothing ignites passion, frustration and confusion in negotiations quite like leaver and vesting provisions. Few other subjects are formed by such closely woven strands of corporate, tax and employment law. On equity deals, leaver mechanics will invariably be amongst the last negotiation nuts to crack.
In this guide, we have aimed to provide a straightforward explanation as to how UK leaver provisions work in the differing contexts in which they are usually found. We also give a view as to what is ‘UK market’ right now in terms of the extent to which the mechanics favour one party or another. What’s market at time of writing, however, will be subject to change.
We have included at the end of the guide input from some of our ‘best friend’ law firms in the US, Singapore and Germany, commenting in each case on the workings of leaver mechanics and market practice in their jurisdiction.
Leaver provisions put management and employee equity at risk
The primary purpose of leaver mechanics is to incentivise management to remain with a business by putting their equity at risk if they leave that business. If you leave, you lose some or all of your equity depending on why you left. Simple, right?
Well yes, but the mechanics need to deal with why and when a manager might leave and how the equity is ‘lost’, and there is a world of possibility out there in terms of why a manager might leave. It’s complicated.
There is also an emotional value that attaches to management equity beyond the financial, and the mechanics by which that equity is put at risk and is restricted can have highly personal ramifications for the individual manager as well as the employer company. It’s personal – from management’s perspective, they are the ones who take the career risk and do the work.
There are many different ways in which to construct leaver mechanics and there is a wide spectrum as to what is ‘market’. Further still, how the leaver mechanics work is usually utterly dependent upon the context in which the manager or employee has obtained the equity put at risk.
Context is key
Reading up on how leaver mechanics are ‘supposed’ to work can be confusing if not infuriating. Much of the literature online only looks at leaver provisions in one particular context (a seed stage tech venture for instance), and this can then cause a great deal of confusion if the reader is thinking about leaver provisions in a different context (such as an MBO).
And just when you think you have cracked your understanding as to how leaver mechanics ‘should’ work, relative bargaining positions in the market change and with them what is ‘standard’ for management leaving a business.
And then of course market practice differs between jurisdictions.
Where you find leaver provisions
There are four principal contexts in which leaver provisions are usually found:
| 1. In the articles of association of a private equity backed buy-out vehicle, usually applying to the sweet equity held by the management team. | 2. In the articles of association of a venture capital backed company and applying to the class of shares in that company held by the founder team. |
| 3. In the rules of a share option scheme applying to options over shares to be granted to employees. | 4. In the deferred consideration mechanics of a sale and purchase agreement applying to shares in the buyer issued (or to be issued in the future) in consideration for the acquisition by the buyer of the entire issued share capital of the target company. |
Leaver provisions work in most contexts, jurisdictions and cultures
The four contexts outlined above are not exhaustive. Leaver provisions may be relevant in any scenario where employees, managers or other officers (or sometimes even consultants) hold equity interests in the company that engages them (or any group company).
It is not unusual for a manager to hold shares that are subject to leaver provisions in the articles while at the same time, for instance, holding options (over a different class of share) which are subject to a different set of leaver provisions in the option rules.
Sometimes you see leaver mechanics written into put and call options or in a joint venture scenario, but these are even more likely to be context specific and drawing out conclusions as to what is market is largely meaningless or, in any event, beyond the scope of this guide.
If dealing with a company or parties subject to Sharia / Islamic laws then leaver provisions need to be carefully tailored so that they are ‘non-confiscatory’.
Be careful with cookie cutters
The terminology for the constituent principles of leaver mechanics can be applied across the contexts. We get into that further below. But the commercial drivers in each context, and the relative negotiating positions of the parties, can be radically different.
Nevertheless, very often on a transaction one party (or even sometimes its lawyers) will have seen leaver provisions working in one context (a management buyout, say) and then argue to replicate those provisions (sometimes on the basis of not much more than mere familiarity) in a different context (such as on a seed funding round for a start-up). The result is usually far from optimal in terms of the language put forward and then also in terms of the costs and time incurred in negotiating to make it fit the context. Resulting tempers often fray.
Nuts, bolts and moving parts
To understand how leaver mechanics work in any context, you need to understand the nuts and bolts of those mechanics. Here are the principal moving parts to understand:
| Getting equity back once given away
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Once equity is granted or issued to management, directors or employees, a company will need a legally binding but fair mechanic of some kind to get it back. An obvious but fundamental point to bear in mind when dishing out options and shares. |
| The equity at risk
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Obvious really, but the leaver provisions must attach to the specific equity that the parties want to put at risk.
When dealing with shares that have been put at risk, leaver provisions should preferably be ‘hard wired’ into the articles of association of the issuing company rather than working as an agreement between the manager personally and the other parties to a shareholders’ agreement (signing up in their personal capacities). That later approach does work contractually, but it’s generally considered better (and more likely to be enforceable) to have the mechanics included in the articles. There may also be tax advantages to including the leaver restrictions in the Articles depending on the structure. Note that the articles are a public document, so including leaver provisions there may not suit a company that is concerned to keep them confidential. Where a manager can move his or her shares to ‘permitted transferees’ under the articles then the leaver provisions should work so that the restrictions still apply after any such transfer (harder to achieve in the drafting if the provisions are included in the investment or shareholder agreement). In a buyout scenario, management may hold more than one class of share but usually only the sweet equity is subject to leaver provisions. |
| Leaver triggers – ceasing to be an employee
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Who is a ‘leaver’? It’s just if the manager ceasing to be an employee, right? Well, be careful…
The process of ceasing to be an employee needs to be carefully handled so as to comply with notice periods, periods in the ‘garden’ and employment law. Employment contracts have notice periods and employees have statutory rights, and so ideally the trigger for enforcing the leaver mechanics should (from a company/investor perspective) be the point at which notice of termination is served regardless of what happens thereafter. In this case, care is required when drafting the interaction between leaver provisions and exit provisions. So too be careful to follow the process prescribed under the articles and company law when removing a director. Who pulls the trigger? Where it’s not the employee voluntarily resigning, think about who is making the decision to remove the employee. In a context of a buyout – where the invested fund controls the company and the board – the fund will do the firing and hiring. In a venture capital context, however, the investor has a potential problem. It doesn’t control the board. It can’t tell the directors what to do (notwithstanding that it will have veto and consent rights). If a co-founder is underperforming and should be managed out of the business, then the investor is going to be reliant on persuading the other founders to do the managing out. Careful drafting across the document suite can plot a way around this issue… |
| Additional leaver triggers
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From the point of view of the investor/fund and the employing company (and the remaining managers perhaps), ideally the definition of a leaver trigger includes not only ceasing to be an employee but also other events where – whether or not employment comes to an end as a result – the leaver provisions automatically kick in.
These usually include the following events –
From a management perspective, expanding the scope of the leaver triggers in this way might seem alarming but it is hard to argue against the above since whether or not they happen should remain within control of the individual manager. And managers who remain with a business are usually aligned with the company/investor when another manager leaves the business (and so may be thankful one day that the leaver triggers were expanded in this way). |
| Classification of leavers (and world of possibilities)
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If your mechanics properly identify when a manager becomes a ‘leaver’, then you need to think about whether you want to take account of the circumstances in which they left.
You might think, for instance, that a manager who has defrauded the company and gone to prison should be treated differently to a manager who has fallen ill through no fault of her own. There is a world of possibility out there and careful thought should go in to carving that up into differing classifications of leaver… |
| Bad leavers
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Most commonly, the drafting is being put forward by the investing fund or the employing company. The fund or the company will want to define bad leavers as being anyone who is not within the limited category of good leavers.
Management, if they have the leverage in negotiations, will ask for the reverse and have the language identify the specific circumstances where they will be a bad leaver (absent which they will be good leavers). Not many management teams in the UK have the leverage to win this point (and if they do win it then for those managers that stay with the business it may actually backfire if one of their number leaves and is treated too leniently from their perspective as a result). |
| Good leaver
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Usually, language put forward will say that managers leaving for these reasons will be good leavers:
The drafting should also include a discretion allowing the investing fund or employing company to determine that a leaver is a “good leaver” (even if he wouldn’t otherwise qualify as such) – there may be circumstances not captured above to merit this. |
| Grey/intermediate leaver
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On some deals, the categories of leaver will not split neatly into two, good and bad. A further definition of a ‘grey’ or ‘intermediate’ leaver is needed and will likely be a manager leaving in a defined set of specific circumstances.
Usually, this is a manager leaving the business other than in circumstances where he or she could have been or was dismissed for cause. Usually, you see grey leavers have a vesting schedule in a construct where:
and vesting will usually run by reference to time and not by reference to the achievement of milestones, although it technically can. |
| Treatment of leavers | With the categories of leaver set, the drafting should then make clear how each type of leaver is treated upon leaving the company.
One or more of the following may then apply:
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| Vesting or earning the equity
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Rather obviously, time itself can be a variable. If you want to differentiate between the treatment of equity by reference to the date a manager left the business, then some sort of vesting schedule or formula will be needed.
By way of example, an option plan may provide for options to vest (and thus be earned) over time (e.g. a proportion vests each month), and that good leavers will be allowed to keep their vested options, whereas unvested options will lapse. This is very common. In addition, the employing company could be given a discretion to accelerate the vesting of unvested options – so there are plenty of permutations! |
| Transferees
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If a leaver’s shares are put up for sale, then you will need to legislate for who gets to acquire them and in what order of priority.
Bear in mind that if it is the company buying back the shares to hold in treasury or cancel then the company will need an equivalent value in positive distributable profits to the purchase price (or go through a reduction of capital). Company law is prescriptive about how this can be achieved. Consider also that stamp duty will be payable (at the rate of 0.5% of the consideration payable for the shares) on the transfer of the shares. And there could be employment tax implications, depending on the amount of consideration payable relative to the shares’ fair market value. For example, if the shares are acquired by a remaining manager for free or at less than fair market value then that manager’s position as regards income tax and NICs should be examined (and the employer’s NICs position). If the company buys back the shares, then there is a risk that the difference between what the manager paid for the shares and the price paid by the company is treated as a distribution and taxed as a dividend (i.e. subject to income tax) rather than capital gains tax. Or if a leaver sells his shares for an amount in excess of fair market value, income tax and NICs (including employer’s NICs) may arise in respect of the excess. Those situations could potentially arise in circumstances where the leaver provisions provide for a formula to determine the consideration to be received by leavers for their shares. Applying such formula may produce an amount which is different from the shares’ market value (as determined for tax purposes). |
| Power of attorney
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Leavers might not want to play ball and sign stock transfer forms, for instance. A power of attorney should be positioned within the document suite so that documents can be signed on behalf of the leaver and the mechanics railroaded through without being beholden to the leaver.
Some companies use nominee arrangements so that the managers’ names are not required to be public at Companies House – for smaller holdings this still works. Transfers of interests behind such nominee arrangements is invariably simpler than where the legal title needs to be transferred by a leaver. |
| Tax
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There are specific leaver provisions in many HMRC approved share plans to consider. Sometimes the leaver mechanics have to be tweaked to ensure compliance and secure favourable tax relief. |
What’s market right now – buy-out
In the context of a buy-out, management are being issued with so-called sweet equity effectively for free or at least at a heavily discounted price. That equity will be in an established (and, post-close, nicely refinanced) business and management should be on competitive salaries with a bonus package to boot. The invested fund will be looking to build out the business and then exit within say three to five years and so will want management to be completely aligned on that journey to exit. Private equity does not invest on a volume basis – the buy-out absolutely has to work for the fund, and its representatives on the board will be closely involved in the running of the business (if not perhaps running the business themselves). The fund manager will control the board. The fund expects to see at least a single-digit multiple of the investment returned to it on exit.
The target business will likely have been valued on a conventional basis by reference to some multiple of EBITDA or net assets. And valuations given to the management equity are usually meaningful.
Although management may have been the founders of the business, they are also sellers in the buy-out and are receiving value for their shares in the business. The sweet equity now issued to them is looking forward, starting from completion of the buy-out.
Some thought should also go into the tax treatment of an issue of sweet equity – it will be in all parties’ interest to structure this so that future increases in equity value are treated as capital (and will therefore be subject to capital gains tax on sale) rather than income (which would be subject to employment taxes).
With that background, it should be easy to see that the fund manager will want management on robust leaver provisions: if they leave the business for any reason, then all of their equity goes up for sale and the leaver only sees any value for it in restricted circumstances of being a good leaver (absent agreeing a deal at the time with the fund manager).
What’s market right now – venture capital-backed company
Venture capital is different. First up, the business is high risk – management, or the founders, might spend ten years or more working round the clock on it, and it might still all come to nothing before they can exit with any value. These people could often be on much higher salaries and bonus packages working in industry elsewhere without the stress of worrying about cash flow and with everything reliant on them. The founders also set the whole thing up and will not have extracted value.
Second, the venture capital fund is not going to be involved in the day to day running of the business at all and does not control the board. Venture capital spread bets across quite a number of high-risk companies, many of which will fail or give a near zero return and perhaps one of which the fund hopes will be that home run that returns a multiple of the entire invested fund across all investments.
Third, valuations of fast growth venture capital-backed companies are – at best – educated guesses and – at least in part – a compromise between management and the investor to achieve a higher price than the last round, to give the investor enough of the equity so it feels comfortable and also to leave enough equity on the table so that the management team won’t be diluted into oblivion on future funding rounds.
The level of risk in the business, the absence of objective meaning in the valuation of the business and the difference in leverage between management and investors means that a much wider spectrum of leaver mechanics is seen in the venture capital space than is the case for buy-outs.
Leaver provisions from a fund manager’s perspective ideally work as follows (absent doing a deal with the fund manager at the time of leaving):
- The shares vest over time, usually over a two to five year period. The fund has gone in at a valuation of £x and paid for its shares. Valuation £x gives a founder’s shares a valuation of £y, but the founder hasn’t paid for that equity in cash and is instead going to ‘sweat’ for it. If the founder leaves the business, then there should be a distinction between the equity that has vested (or been earned) and that which remains unvested.
- If the founder is a good leaver, then he or she loses any unvested shares but either keeps her vested shares or her vested shares go up for sale at fair market value.
- If the founder is a bad leaver then she loses both vested and unvested shares
- And ‘loses’ in this context usually means putting the shares up for sale at the lower of fair market value and nominal value. However, due consideration should be given to converting those shares into worthless deferred shares – this effectively takes the equity off the cap table and gives the rest of management and the investor a corresponding uptick in their equity percentage. (Before one uses the deferred share mechanism, one needs to take into account whether any EIS or entrepreneurs’ relief issues arise.)
- Ideally, these mechanics continue notwithstanding that the vesting period has expired, although the founders will argue that once the vesting period has ended the shares are fully ‘earned’ and should be held on the same basis at the fund’s shares which were paid for in cash at the outset.
At the time of writing, there is an oversupply of capital out there for the best and sexiest technology ventures. When it comes to leaver provisions, that means the founders have increasing scope to negotiate. On some deals we have seen founders managing to agree that they lose or have to sell their shares only in circumstances of fraud or having committed a criminal offence but not otherwise.
What’s market right now – option schemes
Option schemes come in many shapes and forms. What type of scheme is suitable for a particular company will depend on the company’s size, set-up, commercial aims and on the nature of its business.
Share options are a great tool for recruiting, retaining and motivating employees. A share option is a essentially a right to acquire a set number of shares for an exercise price determined upfront (usually no more than the shares’ fair market value as at the time of grant).
The rules of the scheme and the terms of the employee’s individual option agreement determine when an option vests and when it becomes exercisable. The employing company can structure this in a way that best suits the business. For example, vesting may happen over time, where all the employee needs to do is to remain employed or may be subject to the employee meeting certain performance conditions.
From the employee’s perspective, the option is a low-risk opportunity to acquire an equity stake in the employer company – after all, nothing can force the employee to exercise vested option that are ‘under water’ (i.e. the exercise price is more than the market value).
From the company’s perspective, the employee’s chance of eventually participating in a successful exit will motivate her to pull her weight. At the same time, the hassle associated with employee shareholders holding actual shares (including having to recover such shares in a leaver situation) can be avoided if the option is structured to be ‘exit only’. This means that, even if vested, the option would only be exercisable on the occurrence of an exit, to allow the employee to share in the exit proceeds.
The choice of scheme is often tax motivated – unless an option qualifies for preferential tax treatment (such as enterprise management incentive (EMI) options), any gains realised by the employee on exercise will be taxed in full as employment income and thus be subject to income tax and NICs (including employer’s NICs).
EMI is usually the scheme of choice for companies that meet the EMI qualifying criteria. EMI schemes are specifically targeted at smaller, higher-risk trading companies (and are often suitable for start-up technology companies).
Where a qualifying EMI option is granted at an exercise price of no less than the underlying shares’ market value (as at the time of grant), no employment taxes arise on exercise (assuming all relevant EMI qualifying criteria continue to be met). Instead, any option gain will be subject to capital gains tax at the time when the shares acquired on exercise are sold. Shares acquired on the exercise of EMI options will usually qualify for entrepreneurs’ relief, which means that the rate of capital gains tax may be as low as 10%. Using EMI where possible is a no-brainer!
An EMI scheme (like all share schemes) should include robust leaver provisions that ensure options held by ‘bad leavers’ lapse immediately on cessation of employment. ‘Good leavers’ are usually allowed to keep their options to the extent vested, in which case there are two potential avenues:
- The scheme could provide for vested good leaver options that are not currently exercisable to become exercisable on cessation of employment (and to lapse if not exercised within a set period of time). The downside of this is that, if exercise results in the employee acquiring actual shares, the company would then need to recover those shares, e.g. through leaver provisions in the articles. For an EMI option to retain its tax benefits, it must be actually exercised, which means the issue cannot be circumvented by cash-cancelling the option.
- Alternatively, the option could continue on its normal terms. Where a scheme is ‘exit only’ option, this would mean that vested options of a good leaver would be exercisable only on the occurrence of an exit event (which could be long after the leaver has left). For the company this would have the disadvantage of having to keep tabs on the leaver. Besides, if an EMI option is exercised later than 90 days after the cessation of employment, at least some of the tax benefits are lost, resulting in income tax and NICs being payable on exercise.
Many option schemes leave this point flexible for the employer company, so that vested options of good leavers continue on their normal terms, unless the employer company exercises its discretion to provide for an early exercise window.
Some companies choose to set things up so that all leavers (whether ‘good’ or ‘bad’) lose all of their unexercised options (whether vested or unvested). This approach is less common (and may be perceived as unfair). However, it avoids the label ‘bad leaver’ in the option documentation and simplifies matters in a leaver situation.
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What’s market right now – US
Written by Vivek Boray (vivek@inventuslaw.com) of Inventus Law (https://inventuslaw.com)
Founders of venture-backed technology companies
In the US, the standard vesting schedule for equity owned by founders of venture-backed technology companies and companies intending to raise VC money is four years with shares released from the repurchase right of the company in equal monthly increments.
It is US market practice to provide the founders with “double trigger” acceleration of 100% of the unvested shares with a termination without “cause” or resignation for “good reason” (a “good leaver” in UK parlance) being one “trigger” and a “change in control” of the company being the other “trigger”. It’s important that “cause”, “good reason”, and “change in control” are precisely defined in the founder’s stock restriction agreement so as to minimize ambiguity.
What happens if a founder is terminated for cause or resigns for no good reason? It’s common for the founders to be able to walk away with all of their vested shares. However, an investor may be able to provide for the ability to automatically buyback at all of the founder’s shares at the original purchase price if the founder were to be terminated for cause.
Also, a clause allowing the company to buyback vested shares at the price per share of most recent financing could be introduced. Founders generally don’t like this for obvious reasons.
Non-Founders of Venture-Backed Technology Companies
Most non-founders of start-ups are issued stock options with a standard vesting schedule of four years with a 1-yeary “cliff” of 25% and monthly vesting in equal 1/48th increments thereafter. Absent some special circumstance, non-founders aren’t afforded any vesting acceleration.
When a non-founder leaves the company, regardless of the circumstances, all options related to unvested shares are automatically terminated, and the non-founder usually has 3-months following termination to exercise the vested portion of the stock option.
Provisions could be included allowing for the termination of the entire option if the non-founder was terminated for “cause” and allowing for the cancellation of the vested options at a pre-determined price usually tied to the company’s most recent financing valuation.
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What’s market right now – Singapore
Written by Ronald JJ Wong (ronald.wong@covenantchambers.com) of Covenant Chambers (https://www.covenantchambers.com)
Founders of venture-backed technology companies
In Singapore, it is market that founders’ shares are subject to vesting over three to four years, a one-year cliff, and with the remainder vesting monthly or quarterly thereafter. Vesting and cliff periods apply to non-founders under option plans, but are typically over a shorter period, e.g. two to three years.
Unvested shares may not be transferred, unless the transfer is made with the consent of the Board and the investors.
If a founder leaves the company voluntarily or is terminated not for cause, the founder will keep the vested shares. The founder’s unvested shares may be subject to a call right by the company to repurchase all unvested shares held by the founder at a stipulated price (e.g. based on company valuation at original investment or valuation at most recent financing round) or price to be assessed.
If a founder’s employment is terminated for cause or a bad leaver event occurs (which is defined in detail) unvested shares may be repurchased for a nominal amount. Vested shares may be repurchased at a stipulated price or a price to be assessed.
If an exit event occurs (e.g. sale or merger of the company to a third party or public listing), or in the event of a founder’s death or permanent disability, all unvested shares typically vest immediately prior to such event.
Non-Founders of Venture-Backed Technology Companies
Non-founders often participate in the equity through an option scheme. If a non-founder voluntarily leaves the company or is terminated by the company not for cause, options related to unvested shares are typically forfeited. As regards vested share options, the non-founder may exercise the option and take the shares or sell the options back to the company for a price based on the option plan.
If a bad leaver event occurs, both vested and unvested share options may be forfeited.
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What’s market right now – Germany
Thomas Sasse (thomas.sasse@corplegal.global) and team of CORPLEGAL Werner & Partner mbB (http://www.corplegal.global)
In Germany, many of the nuts, bolts and moving parts of leaver mechanics work in a very similar way to their workings in the UK and elsewhere in the world. The workings, however, need to be placed in the context of German statutory law… click here to read on about market practice in Germany.
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If you would like to discuss leaver provisions on a particular deal or transaction, or if you think we left anything out of this guide, then do please contact us at enquiries@humphreys.law.
The UK aspects of this piece were researched and prepared by Henry Humphreys, Annette Beresford, Jeremy Glover and Amir Kursun.
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