The good, the bad and the ugly:
negotiating leaver and vesting provisions on venture capital deals

Published: 5 December 2020

The most comprehensive guide you are likely to find on understanding and negotiating leaver and vesting provisions on VC deals.

How can founder equity be clawed back…?

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.

This Guide provides a straightforward explanation as to how UK leaver provisions work but is principally focused on leaver provisions as they apply in the venture capital industry. Also included are thoughts on the subject from our friends at independent law firms in some of the major technology jurisdictions.

Do please note that what is ‘market’ at time of writing will be subject to change and will always differ between jurisdictions.

This piece was compiled by Henry Humphreys, Annette Beresford, Jeremy Glover, Nick Westoll and Lucy Ganbold, with input from best friend law firms overseas.

The good, the bad and the ugly

negotiating leaver and vesting provisions on venture capital deals

Leaver provisions put equity at risk

The primary purposes of leaver mechanics are:

  1. To incentivise the founders to remain with the business by putting their equity at risk if they leave.
  2. As a value adjustment mechanism. The investor has paid for its shares at a certain pre-money value, which therefore values the founders’ shares at the post-money value. Venture capital valuations, however, are forward looking and predicated on the venture reaching scale and a major exit one day. And the investor – looking ahead to that eventual exit one day – will be assuming that the founders will be working for the venture for some or all of the time needed to get there. If a founder bails out before that exit then fairness would suggest that she loses some or all of her equity.

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 founder 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 a management buyout).

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 founders leaving a business.

And then of course market practice differs between jurisdictions.

Where you find leaver provisions

Leaver provisions are not just found on venture capital deals. You find them in private equity buy out structures. And in option scheme rules. And sometimes in the deferred consideration mechanics of a sale and purchase agreement in an M&A context.

In fact, leaver provisions may be relevant in any scenario where employees, founders or other officers (or sometimes even consultants) hold equity interests whilst performing services to the issuing company (or a company in its group).

It is not unusual for a founder to hold shares that are subject to leaver provisions in the articles of association while at the same time holding options (perhaps 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, these will be highly specific to the context of each deal.

If dealing with a company or parties subject to Shariah / Islamic laws then leaver provisions need to be carefully tailored so that they are ‘non-confiscatory’. That said, the practice locally by most clients – in the technology space especially – is to keep the documentation to the extent possible under DIFC or ADGM common laws.

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.

Valuations for venture-backed companies are forward looking and usually have nothing to do with what’s on the balance sheet. Investors agree to these valuations because they think that the business might one day achieve massive scale and an eventual exit at a valuation many orders of magnitude larger than the valuation the investor went in at. The founders sell the investors on this vision and valuations are agreed accordingly.

The theory goes then that – at the point of investment – the founders are getting the same valuation for their equity as the investor, and that valuation is also forward looking and predicated on the founders remaining with the business for some, most or all the way to exit. The investors pay for their shares in cash; the founders in (future) sweat. If the founders leave early then the value of their equity needs to be re-calibrated to take account of the fact that the execution of the vision sold to the investor was not completed.

The means by which that re-calibration takes place are the mechanics of leaver and vesting provisions. What those provisions say and how they are structured will never be standardised and will forever reflect the relative bargaining positions of founders and investors, driven by the levels of capital available in the market looking for the hottest deals

Henry Humphreys, Managing Partner, Humphreys Law

Nuts, bolts and moving parts

To understand how leaver mechanics work on venture capital deals, 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

Once equity is granted or issued to the founders, a company will need a legally binding but fair mechanic of some kind to get it back.
This is the fundamental point to bear in mind when dishing out options and shares.

The equity at risk

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 founder personally and the other parties to a shareholders’ agreement (signing up in their personal capacities).

That latter approach does work contractually, but it is 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 founder can move her shares to ‘permitted transferees’ under the articles then the leaver provisions should work so that the restrictions still apply after any such transfer.

Leaver triggers - ceasing to be an employee

Who is a ‘leaver’? Only if the founder is 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 is not the founder 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 does not control the board. It is unable to 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.

So too, a co-founder should consider a scenario where an investor and the other founders resolve to manage out that co-founder.

Careful drafting across the document suite can plot a way around these issues but only if sufficient thinking has gone into legislating for the circumstances of the deal…

Additional leaver triggers

From the point of view of the investor/fund and the employing company (and the remaining founders 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 –

  • conviction of a criminal offence, usually ignoring road traffic offences not punished by way of a custodial sentence;
  • committing fraud against any group company (which actually is picked up in the point above since fraud is a criminal offence, but is usually added so there is no doubt at all about the seriousness of fraud);
  • breaching the restrictive covenants (or other key terms) in a share purchase agreement or shareholders’ agreement (note that whilst the Courts are more likely to enforce covenants in such documents compared to employment agreements, they can still be declared void for public policy reasons if drafted too widely); and
  • bankruptcy.

From a founder 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 founder.

To successfully argue against the inclusion of the additional leaver triggers then a founder would usually have to be able to point to her own employment contract and those trigger events being included there, giving rise if triggered to summary dismissal (and in turn triggering the leaver provisions), but even then the investor – a minority voice on the board – will not on its own be in a position to insist that summary dismissal is forced through.

And founders who remain with a business are usually aligned with the company/investor when another founder leaves the business and so may be thankful one day that the leaver triggers were in fact expanded in this way.

Note though that these additional leaver provisions are not included in the BVCA model documents for VC deals.

Classification of leavers (and world of possibilities)

If your mechanics properly identify when a founder 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 founder who has defrauded the company and gone to prison should be treated differently to a founder who has fallen ill through no fault of her own.

There is a world of possibility out there and careful thought should go towards the differing classifications of leaver…

Bad leavers

Most commonly, the drafting is being put forward by the investing fund’s lawyers or those of the employing company.

The fund or the company will usually want to define bad leavers as being anyone who is not within the limited category of good leavers.

The founders, 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 founder teams in the UK have the leverage to win this point. That said, the BVCA model documents for VC deals specifically define a bad leaver and say that a good leaver is not a bad leaver.

And, if the founders do win it, then for those founders 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

Usually, language put forward will say that founders leaving for these reasons will be good leavers:

  • death;
  • ill health, but then excluding circumstances where ill health was brought on by substance or alcohol abuse; and then think about how long ill health needs to carry on for and whether this might need to be signed-off by a doctor;
  • retirement, and this used to usually say at age 60 or above but should now always cross refer to company policy on redundancy or risk falling foul of age discrimination law (and then company policy should be legally compliant of course, although that is easier to sort post-completion in due course and can flex if necessary);
  • unfair dismissal, and you want the dismissal to be unfair for a substantive reason and not a procedural hiccup; and then you’d want the decision made from the Employment Appeal Tribunal or a Court from which there is no right to appeal);
  • dismissal by the company for reasons other than cause, and ‘cause’ itself should be clearly defined to include gross misconduct, criminal activity, fraud and so on; and
  • voluntary departure by the founder after a period of time (when they could not then have been dismissed for cause), which you do not always see. But in some contexts, it is appropriate for founders leaving after a certain point in time to be treated as good leavers. Often, however, a founder who chooses to leave will be classed a ‘bad leaver’. Or it could be considered whether to put this in a definition of a ‘grey’ leaver (which is considered below).

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 she would not otherwise qualify as such) – there may be circumstances not captured above to merit this.

Grey/intermediate leaver

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 founder leaving in a defined set of specific circumstances.

Usually this is a founder 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:

  • bad leavers get nothing;
  • grey leavers keep/see fair market value for their vested shares; and
  • good leavers keep it all/see fair market value for it all,

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 usually applies:

  • the leaver has to put some or all of her shares up for sale or agree for it to be repurchased by the employing company (with the value to be received on such sale / repurchase depending on the category of leaver);
  • some or all of the leaver’s shares convert into a new class of worthless deferred shares; and
  • nothing happens, the leaver keeps her shares.

Where equity is held as options, then it is much easier to claw it back – some or all of the options simply lapse (which means the contractual right to exercise those options no longer exists).

Vesting or earning the equity

Time itself is a variable.

Most investors will not be comfortable that the founders have in effect earned their shares at the post-money value on the day of the investment.

And the investor will usually want the founders to earn their shares over time by reference to a vesting schedule, typically running for two to five years following completion of the investment.

Actually, it is better thought of as a reverse vesting schedule.
The founders already hold all their shares, but the leaver provisions, if triggered, may cause them to lose some or all of those shares and the vesting schedule helps dictate how many.

Usually, vesting takes place on a monthly basis. In the case of a three-year vesting schedule for instance, 1/36th of the at-risk equity (reverse) vests per month and 100% will have (reverse) vested at the start of the 37th month.

Vesting 'cliffs'

An investor will be wary that a founder may leave shortly after completion of the investment, which of course may impact negatively on the venture; and so watching such a leaver walk away with any vested equity at all may not be palatable.

One-year cliffs are therefore common, where no equity vests in year 1 but at the end of year one the whole year’s equity vests and for the rest of the vesting period it is monthly vesting.

Pre-vesting

From a founders’ perspective, closing the investment round with all her equity at risk under the leaver provisions may feel like a retrograde step. Particularly so if:

  • she has been working for the business for some time at a less than market salary; and/or
  • the new leaver provisions are on a series X round and re-set the vesting clock agreed on the series X -1 investment round.

If she has the leverage to negotiate, that founder can ask that some percentage of her shares are ring fenced away from the leaver provisions on the basis that they have already been earned and should not be put at risk.

Transferees

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) or must comply with one of the other methods under English law for financing a buyback. Company law is prescriptive about how this can be achieved. Instances where it has gone wrong are not unknown to be picked up in due diligence at exit, and the consequences there can be sub optimal to say the least.

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 (including where it occurs pursuant to a buyback). And there could be employment tax implications, depending on the amount of consideration payable relative to the shares’ market value (as determined for tax purposes). For example, if the shares are acquired by a remaining founder for free or at less than market value then that founder’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 founder 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 or her shares for an amount in excess of market value (as determined for tax purposes), 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

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.

HMRC approved share plans

In some HMRC approved share plans, the leaver mechanics may have to be tweaked to ensure compliance and secure favourable tax relief.

What’s market right now – US
Written by Steve Hurdle of Loeb & Loeb LLP

As in the UK, different contexts call for different leaver provisions. Some, like leaver provisions for rollover equity following a company’s acquisition by a private equity firm or retained equity following a stock acquisition, are highly negotiated and transaction specific. These provisions are designed to give the buyer of the company the benefit of the founder’s or employee’s continued services post-closing by incentivising performance and penalising leaving.

On the other hand, equity grants to founders and employees of early-stage companies (including most technology start-ups, though the same general structure frequently applies to other industries) follow a more consistent formula when the start-up company is a US corporation. US limited liability companies (LLCs) tend to have more heavily negotiated provisions, tend to be more founder-friendly, and therefore have more variety in the equity features. The below descriptions focus on early-stage US corporations.

Founders

Because a founder is involved with her company at a time when the stock of the company is worth zero or near-zero, most founders acquire stock for a purchase price equal to its par value. By doing that, and among other benefits, the founder starts the clock on obtaining favourable long-term capital gains tax treatment (which requires the founder holding the stock for one year or more) upon a sale of the founder’s equity.

Because the founder actually purchases shares outright, the shares are subject to ‘reverse vesting’; that is, the shares are subject to a repurchase option exercisable by the company at the lower of the original purchase price or fair market value if the founder leaves, with the number of shares subject to this repurchase decreasing over time. The remaining vested shares are sometimes subject to a repurchase option exercisable by the company (or, in some cases, one or more investors) at fair market value. The vesting period is customarily four years, and typically lapses monthly or quarterly, sometimes with a delay in the first vesting date for a one-year cliff.

This vesting schedule is commonly accelerated upon the occurrence of a termination by the company without ‘cause’ or by the founder for ‘good reason’ within a specified time before or after a change in control of the company. Because there are two conditions that must be satisfied to accelerate vesting (the termination event and the change in control), this is referred to as a ‘double-trigger’ acceleration.

The definitions of ‘cause’, ‘good reason’ and ‘change in control’ are often heavily negotiated and must be precisely defined to minimise the possibility of disputes around whether an acceleration has occurred.

Alternately, ‘single-trigger’ acceleration, based only on the termination of the founder, is more founder-friendly and is a feature of some deals.
Although a founder may provide for founder-friendly vesting terms (or no vesting at all) in her grant documents, investors often require more investor-favourable terms as a condition of their investment. It is not uncommon for an investor to impose new vesting conditions on shares that have already vested, particularly in the company’s first third-party equity financing.

Non-founders

In contrast to founder stock purchases, most employees will join a company after the company has attained some meaningful level of value. If the employee were to purchase stock, a significant cash outlay may be required.
Alternatively, if the employee were to be granted stock without purchasing it, the employee would be taxed on the value of that stock (for tax reasons, depending on the vesting provisions of the stock award, the tax may arise on each vesting date), resulting in phantom income for the employee.
For that reason, after the very early stages of the company, employees are customarily granted stock options. Stock options are typically subject to four-year vesting with 25% vesting on the first anniversary of the grant date and the remainder vesting in equal monthly instalments. Upon any termination of the employee, unvested options are forfeited without consideration, and depending on the circumstances of the termination, even vested options may be forfeited.
Employees typically have a 90-day window in which to exercise their vested options after termination, after which the company may also have the right to purchase the employee’s shares at fair market value. An employee is usually not guaranteed acceleration of vesting upon termination, but the company’s board may decide to permit acceleration on a case-by-case basis or in connection with a change in control of the company.

Some employees, although not founders themselves, become employed by a company at a time when the stock is near valueless. In that case, the employees may purchase stock outright, subject to buyback provisions of the type applicable to founders, although the terms tend to be less friendly to employees than the founder provisions described above.

An employee may also be granted other equity-like instruments, such as phantom stock. These instruments are more customised to the employee and may or may not provide for vesting and may terminate in their entirety when the employee’s employment is terminated.

What’s market right now – Japan
Written by Yuki Sato of So & Sato https://innovationlaw.jp/

Founders

The venture capital industry in Japan has been strongly influenced by the US. However, vesting provisions have not been very common in Japan. Even today, many of the founders’ agreements require the founders to sell all their shares to the remaining founding shareholders once they leave the company.

While the JVCA does not provide any templates specifically dealing with vesting, vesting provisions have become increasingly common.

Since the founders of the company acquire the shares at the time the company is established, the shares are generally subject to reverse vesting. The vesting periods typically range from two to five years. In many cases there is also a one-to-five-years cliff. Founders generally earn their shares on an annual basis. Shorter earning periods are the exception.

Unlike in the UK, vesting provisions are usually not incorporated into the articles of association but into the founders’ or shareholders’ agreement.

Similar to other jurisdictions vesting provisions in Japan generally distinguish between good leavers and bad leavers. While the details largely depend on the bargaining power of the founders, leavers are generally considered good leavers unless one of the circumstances applies that makes them a bad leaver.

For bad leavers the shares are commonly bought back at the nominal value or the initial purchase price. In many cases, this also applies to the shares that are already vested. For good leavers the price is typically set at the price of the last financing round or fair market value. Yet, it is common practice that the leaver and the remaining shareholders engage in negotiations about the purchase price despite the provisions in the founders’ or shareholders’ agreement.

Non-founders

For employees it is more common to offer stock options than shares. This is due to the fact that there are certain tax exemptions for stock options and that they provide more flexibility in case an employee leaves the company.
If a company provides shares to (leading) employees, in many cases, the employees must sell their shares to the founders or a party nominated by the founders at the purchase price. If the shares are subject to a vesting schedule, the schedule is largely in line with that of the founders.
The vesting provisions may either be included in the employment agreement or a separate contract.

What’s market right now – Australia
Written by Andrew Clark of Talbot Sayer

The Australian venture capital market tends to follow the trends occurring in both the UK and the US and much of what has been discussed above applies equally in Australia with a few notable exceptions.

As with the UK, tax is a key driving factor in determining the most efficient means of issuing equity to employees, and the age, size, and industry in which the company operates will often dictate the type of equity plan that is adopted.

Whilst option schemes, sweat equity and discounted share plans are common, Australian companies also regularly issue shares to employees at market value via a loan funded scheme where the company funds the value of the loan via a nil interest limited recourse loan.  The loan is then repaid via dividends or the proceeds of the exit.  The key advantages to this structure are:

  1. the shares are issued at full market value, which is attractive to existing shareholders;
  2. the employee receives the upside benefit without the downside risk (due to the limited recourse nature of the loan); and
  3. the cost base for capital gains tax purposes is market value meaning no tax surprises on sale.

Other unique features under Australian law include a financial assistance regime that requires regulatory and shareholder approval before undertaking a share buyback (for example in a leaver scenario) or where the company is funding the acquisition of its own shares (such as a loan funded scheme).  To avoid this process and fall within the financial assistance exemptions, equity is usually issued under an ‘approved employee share scheme’.

With companies conscious of the perils of enforcing post exit restraints and the cash flow implications of implementing buy backs, we have seen a number of companies defer payment for leaver shares until expiry of the restraint period.

What’s market right now – Israel
Written by Ariella Dreyfuss, Partner of Barnea Jaffa Lande

In the Israeli start-up world, in an effort to align interests, it is common for the entrepreneurs to agree on a reverse vesting mechanism on their shares in their founders’ agreement.

It is market for the shares to reverse vest over a period of three years, to be released in equal instalments on a monthly or quarterly basis, and for the schedule to fully accelerate on an exit event.

If the founder resigns other than for ‘good reason’, or is terminated for ‘cause’, then she will be able to keep the shares vested to date, and the non-vested shares will be subject to a right of repurchase by the company/remaining founders.

If the founder resigns for ‘good reason’, which may include constructive dismissal, death or incapacity, or if her employment is terminated other than for ‘cause’, the shares will be released from the reverse vesting mechanism.

During the vesting period the founder will be restricted from transferring or pledging her shares.

If the start-up company itself was not a party to the founder’s agreement, or no such reverse vesting agreement is in place, then during the first financing round, the investors will ask the founders to repeat this undertaking to the benefit of the company and in certain cases the investors, particularly if the founders control the company or the board and can therefore unilaterally amend the contract.

Reverse vesting mechanisms are typically codified in contracts, and not in the articles of association of the company (unlike in the UK).

The Israeli Tax Authority may consider a repurchase of shares by the company from a founder as a distribution of a dividend to the other shareholders, which would have tax and corporate law implications for the company. Accordingly, there are customarily mechanisms included in the relevant contracts permitting the company to reclassify the unvested shares into non-voting and non-participating shares, in lieu of repurchasing them.

To reduce the risk that tying the founder’s equity to her engagement by the company might lead the Israeli Tax Authority to conclude that such shares are consideration for the founders’ employment and therefore subject to income tax at a rate of up to 50% (rather than capital gains tax which has a lower tax rate range of 25% – 33%), the reverse vesting mechanism has to meet the following criteria:

  1. it must be agreed in advance and in writing at the time the company was incorporated or soon thereafter, or as a result of a substantial investment in the company (at least 5%);
  2. only the company or other existing shareholders are entitled to buy the forfeited shares, and such sale shall be for no consideration or for their par value;
  3. the relevant shares are ordinary shares, with identical rights to the other ordinary shares in the company; and
  4. but for the reverse vesting mechanism, the gain from the sale of the shares would have been considered a capital gain.

It is market practice to grant employees options (rather than shares) under a tax-efficient program. These options vest over time, typically with a one-year cliff. It is common for the company option plan to provide that if an employee is terminated for cause their vested options will be cancelled.

What’s market right now – UAE
Written by Arjun Ahluwalia of Argentum Law

In the UAE, general market practice for private investments is strongly influenced by UK market trends, largely due to the expansive influence of UK-qualified lawyers and the strong business links between the UK and the UAE.

However, we have observed increasing use of US-style investment term sheets and early stage investment documents adapted for use in the UAE as the early stage venture community is increasingly influenced by trends emanating from Silicon Valley and as investors with US backgrounds are increasingly influential in the investment community.

In our experience in the UAE, in the VC context, founders’ or key persons’ shares tend to be subject to vesting over two to four years, with a one-year cliff, and monthly or quarterly vesting thereafter. Some individuals who are nominated as later ‘co-founders’ or non-founder key persons tend to be subjected to performance related milestones to trigger equity to vest.

In cases where the investment is provided by a non-typical VC investor, such as corporate strategic investors, the vesting terms tend to be more forgiving with the equity being fully vested in the founders but subject to more stringent terms on claw-back of the shares and call options at heavily discounted valuations in the event of any typical ‘bad leaver’ events.

‘Termination for cause’ and ‘bad leaver’ vs ‘good leaver’ events are typically heavily negotiated. For example, there tends to be some emphasis on whether or not to include the full range of criminal acts in the UAE (which tends to cover a wider range of offenses compared to the UK).

Much of the UK market practice relating to vesting of shares applies to expectations placed on UAE-based founders. However, one key difference from UK practice is that since income tax is not applied in the UAE, taxable concerns on share options are not relevant unless the founder is tax – resident elsewhere outside the UAE.

Another departure from UK market practice relating to UAE ventures is that share options have historically been granted in offshore vehicles, such as Cayman/BVI/Bermuda/Delaware etc., due to the fact many corporate vehicle types established in the UAE (onshore or in the free zones) historically have not allowed for differential share classes nor relative ease in registration of shares.

That is, however, changing with the advent of new rules and regulations at the Dubai Multi Commodities Centre (DMCC) (a popular free zone) introducing more flexible equity features and allowing incorporations of vehicles such as special purpose companies available at the Dubai International Financial Centre (DIFC) or the Abu Dhabi Global Market (ADGM). This has allowed founders and investors to structure holdings and share options in a common law-based system.

Given the recent efforts by the free zones generally to encourage business activity due to the effects of the COVID-19 situation, many free zones have offered deep discounts in incorporation packages which have led to encouraging many early stage ventures seeking fundraising to reorganise and restructure their corporate structures to match up with international best practices. For example, by moving holdings previously onshore or in more archaic free zones to common law type free zones such as the ADGM and DIFC, and implementing time and performance based vesting agreements for shares in founders and key persons.

What's market right now – Hong Kong
Written by Katherine U of MinterEllison LLP

In Hong Kong, it is common for a company which is listed or planning to be listed to set up share incentive schemes as a means of rewarding and incentivising not just the founders and employees of the company and its subsidiaries but the consultants, business partners and other third parties who contribute to the growth of the company as well.

Share option schemes are the most common type of incentive schemes used in Hong Kong although many companies now have schemes such as restricted share unit schemes, share award schemes and share purchase schemes in addition to their share option schemes.

Unlike share option schemes which involve the issuance of new shares to the option holders, restricted share unit schemes and share award schemes usually involve the transfer of existing issued shares, or the proceeds of sale thereof, to the holders of the units or awards, and will thus have a different impact on the issued capital and financial position of the relevant companies.

Regardless of the type of scheme used, the vesting of options or awards are usually subject to a vesting schedule of three to five years, often coupled with specific performance targets as well.

There is usually little distinction amongst the different types of incentive schemes in their treatment of good leavers, bad leavers and grey leavers. Companies which have more than one type of share incentive scheme usually treat the good leavers, bad leavers and grey leavers in substantially the same way across the schemes.

If a holder of an option or award becomes a leaver (good, bad or grey alike), the unvested portion of her option or award will usually lapse immediately. One exception provided in some schemes is to allow unvested options or awards to vest immediately upon the death of the holder of such options or awards.

A good leaver (typically someone who leaves by reason of retirement, redundancy, death, ill-health, injury or disability affecting her ability to continue in her role, or termination other than for cause) is usually allowed to exercise her vested but unexercised options or receive her vested award shares or proceeds of sale thereof within a short period of time (e.g. within one month after the date of her departure (and such date is usually defined in the scheme rules)).

If the departure is caused by death, ill-health, injury or disability, the good leaver (or in the case of death, her personal representative(s)) will usually have a longer period (e.g. within a period of 12 to 24 months from the date of departure) to exercise the options or receive the award shares or sale proceeds.

A bad leaver (typically someone who is terminated for cause, guilty of serious misconduct, or convicted of any criminal offence involving her integrity or honesty) will usually see her vested but unexercised options, or vested but not-yet-transferred award shares, forfeited. Nevertheless, it is uncommon for shares which have already been issued or transferred to the bad leaver to be clawed back.

A grey leaver (typically someone who resigns) is treated in a less consistent way by companies than a good leaver or a bad leaver. Some companies treat those who resign the same way as they treat bad leavers and forfeit the vested but unexercised option or vested award shares, while other companies do the opposite and allow those who resign to exercise or take their vested options or awards within a short period time.

What’s market right now – Italy
Written by Antonia Verna and Daniel J. Giuliano of Portolano Cavallo

Leaver provisions structured as put-options: when they are valid or not according to Italian case-law

It is common in the Italian market to find leaver provisions amongst the provisions that govern post-investment relationships with founders of venture-backed companies.

In the Italian market, leaver provisions are typically found in shareholders’ agreements or other ancillary agreements.

Occasionally, the parties may attempt to structure leaver provisions using a put and call mechanic. Care must be taken with put options.

Put-options are where the founder has the right to sell upon becoming a leaver at a predetermined price or at a price determined based on a predetermined formula depending on the triggering event.

Put-options, however, may conflict with the Italian Civil Code which states that shareholders cannot be entirely excluded from sharing profits or losses (divieto di patto leonino).

Leading case law agrees, put-options are null and void when they provide for the permanent and total exclusion of a shareholder from sharing the profits or losses.

Rulings from the Italian Supreme Court also state put-options are not valid if they are included in the company’s articles of incorporation.

Law and legislation act so as to restrict put-options from altering the statutory rules governing the relationship between the company and the shareholders.

Leaver provisions included in incentive schemes

Start-ups and small/medium sized businesses in Italy are usually structured as limited liability companies (LLCs).

Many LLCs make use of equity incentive schemes in favor of their employees, directors and independent service providers (and have done so since 2012 when a new regulation on start-ups was introduced).

Under the rules:

  1. LLCs can purchase their own equity, provided it is for the implementation of an incentive scheme (as an exception to the general principle preventing LLCs from carrying out transactions involving their own equity).
  2. There are certain tax advantages associated with the financial instruments or other rights (and options to acquire such instruments and rights) assigned by innovative startups to employees, directors and external staff. For example, subject to certain conditions, financial instruments and other rights acquired by virtue of an incentive scheme do not form part of the assignee’s income for tax and social contribution purposes.
  3. There are tax advantages similar to those mentioned in point (2) above in respect of equity and participative financial instruments assigned by innovative startups to independent providers in consideration of the service or work performed in favor of the company.

The tax advantages stated above in (2) and (3) are only applicable to companies that fall under the definition of ‘innovative startup’. For a company to meet such definition it must meet certain specified criteria including, inter alia:

  • it must not have been established for a period longer than five years; and
  • its main business purpose must be to produce and market high-technology services and products.

What’s market right now – Singapore
Written by Kyle Lee of WongPartnership LLP

Founders

In Singapore, it is typical for founders’ shares to be subject to reverse vesting, with such vesting taking place over three to five years and on a monthly basis with a one-year cliff to start.

Instead of being built into the constitution of the issuing company, market practice is that such vesting provisions tend to be dealt with via contractual agreement either in the shareholders’ agreement or in the employment / founders agreement, given that the constitution is publicly searchable.

Founders may also sometimes bring up commercial reasons to argue that the start date of the reverse vesting should be a point in time prior to the investment round in question.

While we have seen many ways of slicing and dicing the good leaver / bad leaver concept, a more common formulation would be to specify the categories of events which would lead to a departing founder being a deemed a bad leaver, with the good leaver correspondingly being a departing founder who does not fall within such category.

For bad leavers, it is typical that all shares (vested or unvested) are bought back at nominal value, i.e. 1 cent per share. Good leavers on the other hand are typically entitled to keep their vested shares but such vested shares may still be subject to buyback at fair market value.

Non-founders

Typically, employees would be incentivised via the employee share option scheme of the company, which would similarly provide for vesting of the options over time with a cliff period.

A departing employee would typically forfeit her non-vested portion of the options, while having a specified time-period after departure in which to exercise her vested options.

What’s market right now – Germany
Written by Dr. Lorenz Jellinghaus of Lutz Abel

Founder vesting

In Germany ‘founder vesting’ is a widespread mechanic for VC-backed companies and UK market practice is familiar to the German market.

In Germany, all shares are issued and acquired by the founder at once when founding the company and the founder grants a call option (or a similar instrument) to the company or to a third party. As with the UK, vesting is better thought of as reverse vesting.

If the founder leaves the company during the vesting period, the entitled entity/person has the right to exercise its call option. The number of shares the call option applies to is determined by the elapsed time in the vesting period and dependent on whether the founder is a good leaver or a bad leaver.

The terms of the founder vesting are usually incorporated in the shareholders´ agreement.

As in the UK, shares need to be purchased at fair market value for the purposes of German tax law so as to avoid unwanted dry tax charges. Founders therefore are – ideally – issued with all of their shares upon incorporation when there is little to no value in the company.

Non-founder vesting

Non-founder vesting takes place only within the framework of an employee participation programme in which employees are entitled to a cash bonus in the event of an activating event (usually a share sale or an IPO).

The level of these entitlements is based on the value of allocated virtual shares (or phantom stocks) granted to the employee. Those virtual shares are taxed as income upon an activating event, which is not particularly tax efficient.

Looking ahead in Germany

Following criticism of the employee participation model, the German government is currently considering modernising the employee share ownership system in Germany and making equity share ownership economically attractive for employees in the future.

The plan is to tax equity shares only in the event of an activating event, that is when an actual return in cash is possible. Employees would then have to pay a rate of 25% tax on the shares. This is equivalent to the capital gains tax that would also apply, for example, to normal transactions on the stock exchange. A first decision is expected in 2021.

What’s market right now – France
Written by Morgan Hunault-Berret and Salim Bencheikh of Villechenon

Leaver mechanisms in France work in a very similar way to those in the UK. The French specifics are as follows.

Corporate officer equity holder vs employee equity holder

The legal regime applicable to leaver provisions depends on whether the holder of the equity subject to the leaver provision is a corporate officer (mostly bound by a mandate agreement) or an employee (bound by an employment contract).

In a nutshell, leaver provisions applied to corporate officers may be freely drafted in terms of classification of leavers and discount applied to the clawed back equity, whereas those applied to employees will need to be cautiously drafted given the constraints triggered by the application of employment and case law.

Founders of venture-backed companies will usually hold the position of CEO, Managing Director, or similar positions and thus be bound, in most cases, by a mandate agreement. Accordingly, reference to corporate officer(s) in this article includes founders of venture-backed companies when they hold such position.

Corporate officers

Vesting schedules vary from three to five years and usually include a one-year cliff of 25%. There is no established practice on the vesting periods that will need to be negotiated between the parties. The current trend would however be to provide for monthly or quarterly vesting periods.

In most transactions, 100% of the equity of the corporate officer is at risk and may be clawed back whether vested or unvested. The classification of leavers may however be freely negotiated and there is, also, a world of possibilities.

A differentiation between bad and good leavers is most common, but intermediate leaver cases may also be provided for.

The definition of bad leaver would include, for example:

  • a resignation of the corporate officer during the first three to five years; or
  • as long as the leaver provision is in force and in effect: any breach by the corporate officer of certain important provisions of the shareholders’ agreement, willful misconduct (faute lourde) or gross negligence (faute grave).

The current trend though takes a more founder friendly approach regarding gross negligence (faute grave) which is classified as a good leaver or intermediate leaver case.

The definition of good leaver includes the other cases of departure including prolonged sickness, death or resignation after three to five years.

The price of the clawed back equity is usually determined linearly depending on:

  • the classification of the considered leaver (bad, intermediate, good);
  • whether the shares are vested or unvested; and
  • the date of the departure.

In practice, prices vary from the:

    • nominal value (or 10% of the market value) for unvested equity in good/intermediate leaver cases; or
    • for bad leaver cases to the market value for vested shares in good or intermediate leaver cases.

The criteria on which the market value is fixed may be determined in the shareholders’ agreement, the valuation of the company in its last fundraising or by an expert in case of disagreement of the parties.

Employees

Employment law will apply where leaver provisions involve employees, and this is where we find the hard nut to crack.

French employment law allows disciplinary sanctions on employees but prohibits financial penalties.

Based on this law, employees have attempted to challenge the discount applied to the purchase price of their equity as bad leavers before court arguing that the discount applied to the purchase price is a disguised disciplinary financial penalty and thus prohibited.

French case law is however not entirely fixed and legal doctrine seems divided.

The validity of leaver provisions involving employees is subject to the fulfilment of the following conditions:

  • the leaver provision does not include a classification of the leaver cases;
  • the discount, if any, applied to the clawed back equity is applicable in any case of departure without distinction (the same discount should be applied to the resignation, dismissal or willful misconduct of the employee (faute lourde)); and
  • any dismissal without actual and serious basis (licenciement sans cause réelle et sérieuse) will give employees the right to seek compensation for the damage suffered as a result of the discount applied to the clawed back equity.

There is, however, a grey area in law and covers the circumstances where leaver provisions including a discount is triggered following a disciplinary sanction imposed on the leaver employee.

Case law and legal doctrine are further grey on whether the applicable sanction related to the invalidity of a leaver clause applied to an employee would be:

  • the payment by the employer of the difference between the market value of the clawed back equity and the discounted price paid to the employee in application of the leaver provisions; or
  • the nullity of the whole leaver provision.

To avoid a maximum of risk where a leaver provision is concluded with an employee, a cautious approach would be to have the purchase price of the clawed back equity fixed at market value as determined by an expert (in addition to the absence of classification of leaver cases).

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 was researched and prepared by Henry Humphreys, Annette Beresford, Jeremy Glover, Nick Westoll and Lucy Ganbold.

All the thoughts and commentary that HLaw publishes on this website, including those set out above, are subject to the terms and conditions of use of this website.  None of the above constitutes legal advice.  Much of the above will no doubt fall out of date and conflict with future law and practice one day. None of the above should be relied upon.  Always seek your own independent professional advice.