What are ‘good leavers and bad leavers’ and why are they important?

What are good leavers and bad leavers?

A shareholders’ agreement will typically include a provision for ‘good and bad leavers’, which sets out rules to determine how much a shareholder leaving a company is entitled to for their shares and under what circumstances the shares can be sold.

– Good Leavers

A good leaver’s shares will typically hold the purchase price of the fair market value of their shares on the date of termination of employment with the company. Good leavers are usually those departing from the company on good terms following the action of death, redundancy, mental or physical incapacity impairing their ability to work or departure following a change in the remuneration, duties, or roles as an employee.

A shareholders’ agreement may also include retirement as an action resulting in a shareholder being considered a good leaver. This should be treated with caution as there is no longer a default retirement age and it could be argued that this is discriminatory against both younger and older non-departing shareholders.

– Intermediary Leavers

The company may also want to include a more flexible discretionary good leaver provision which allows the company’s board of directors/committee to determine on a case by case basis whether or not a shareholder is considered a good or bad leaver.

– Bad Leavers

In contrast with a good leaver, the purchase price for a bad leaver’s shares will be at a considerably lower percentage of the fair market value of their shares on the date of termination of employment with the company. Bad leavers are usually those departing from the company on bad terms following conduct that is detrimental to the company’s reputation or business. Examples may include being a party to fraudulent activities, breaching contracts or the shareholders’ agreement, acting beyond the remit of their authority or being dismissed for gross misconduct.

Provisions stipulating the terms for good and bad leavers can encourage and incentivise shareholders to depart from the company on good terms in the knowledge that they will be properly remunerated for their shares in the company on their exit.

How to determine the value of a good leaver or bad leaver’s shares

Determining the value of shares in a private limited company can often be difficult and subjective. Shareholders should agree for good and bad leaver provisions to be included in the company’s articles of association, shareholder agreement (if applicable), employment contracts or directors service agreements to determine how share valuations are calculated. These provisions should clearly set out the application of an agreed formula or the requirement for an independent account to be instructed to carry out a valuation of the departing shareholder’s shares in the company.

The next step is to determine who is going to buy the departing shareholder’s shares. If individual shareholders are not in a position to, or do not want to, purchase the departing shareholder’s shares then the onus should be on the company itself. If the company does not have sufficient cashflow to purchase the departing shareholder’s shares then the company could arrange for the shares to be sold to an outside investor, subject to the any rights of refusal in the company’s articles of association.

As previously mentioned, a good leaver’s shares will typically hold the purchase price of the fair market value of their shares on the date of termination of employment with the company. The purchase price for a good leaver’s shares is typically paid in full and in cash on the date that the shares are transferred. A company may choose to include provisions which allows the company to withhold some of the purchase price for the good leaver’s shares to safeguard against the possibility of a good leaver subsequently becoming (or it transpiring that they were) a bad leaver.

The purchase price for a bad leaver’s shares will be at a considerably lower percentage (sometimes 50-75%) of the fair market value of their shares on the date of termination of employment with the company. The shareholders’ agreement or articles of association should clearly set out rules to determine the exact percentage discount to avoid a potential dispute. A shareholders’ agreement may also include sub-provisions for bad leavers, such as a regular bad leaver or a very bad leaver (each with their own reduction rate). The purchase price for a bad leaver’s shares is typically paid in full and in cash on the date that the shares are transferred. If the shareholders’ agreement or articles of association contain sub-provisions for regular bad leavers and very bad leavers then it would be prudent to include provisions which allow the company to withhold some of the purchase price to deter a regular bad leaver from becoming a very bad leaver.

Enforceability of good leaver and bad leaver provisions

Good and bad leaver provisions are enforceable by law and should therefore be drafted with caution and in accordance with the latest employment laws and regulations. A shareholders’ agreement (and any good and bad leaver provisions contained therein) is mutually exclusive with the company’s any articles of association, employment contract and/or directors service agreements. Each document should be drafted consistently and complement one another to reflect a common position of the company.

The importance of mutual exclusivity was demonstrated in Moxon v Litchfield and others – [2013] All ER (D) 133 (Dec) which considered the provisions in a company’s shareholders’ agreement, original and revised articles of association, and various service agreements between the company and other parties. The Court held that these documents were well drafted and Mr Moxon had been correctly classified as a bad leaver. As a result, there was no basis for the Court to intervene and alter the contractual arrangement between the parties.

If a Court concludes that a bad leaver provision is particularly onerous and amounts to a penalty clause then the provision is unenforceable. Penalty clauses are deemed to be oppressive, unconscionable, and out of proportion to the legitimate interests of the innocent party. It is therefore imperative that bad leaver provisions are drafted carefully and are not unduly unfair on the departing shareholder.

In the recent case of Signia Wealth Limited v Vector Trustees Limited [2018] EWHC 1040 (Ch) the company deemed Ms Dauriac to be a bad leaver after she terminated her contract of employment with the company and then argued that the bad leaver clause requiring her to be compensated for her shares at a considerably reduced rate to their nominal value was a penalty clause. The Court considered the relevant tests and held that the bad leaver provision was not exorbitant nor unconscionable, despite a significant reduction in the payment of Ms Dauriac’s shares. The bad leaver provision was therefore enforceable.

This decision highlights the importance of ensuring that bad leaver provisions are carefully drafted to ensure that they do not amount to penalty clauses and are enforceable in England and Wales.

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