Shareholder leavers: the fall out

In start-up companies, founders compete for the best staff. Founders often gift equity to new joiners to attract them.  Many start-ups use the model articles that are provided by the government.

This works splendidly while all the parties are getting on well. It is easy to forget about what will happen if everything does not go according to plan.  The rights of shareholder leavers upon termination of employment are often overlooked.  We see cases where it has been relatively easy to handle the termination of employment. However, with only model articles in place it not so easy to deal with the shares held.

Potential problem areas with shareholder leavers

• Where the shareholder is an employee - The ability to force transfers of shares upon termination of employment only arises if an express agreement has been reached. This is not automatic under the government provisions.  We find the problem is most acute with employee or director shareholders.  The problem can be compounded if the leaver is a founder as often they have a sizeable shareholding.
• Shareholder leavers under model articles - If there are no express provisions, then there will be nothing that the company can do, other than to negotiate a sale of the shares or a company buy back of shares if it can. Sales and company buybacks of shares come with complications. There has to be the money to buyback. And, if the shareholder knows he cannot be forced to sell he may take the opportunity to hold out for what is in reality an over inflated price.
• Valuing the shares -With listed companies a share price is relatively easy to figure out by looking in the Financial Times, but for unlisted companies there is no open market for those shares. The parties may be in a better position to pre-agree what price will be paid for those shares early on in the relationship, as opposed to when the relationship is hostile. The aim of a shareholders agreement is to set out a final position that all parties are going to be happy with, whether they are the seller or the buyer.
• Who gets the leaver’s shares? - A good shareholders’ agreement sets out who is to be offered the right to acquire the leaver’s shares. There is usually a procedural order, so shares are first offered to the company. If refused by the company, to the largest shareholder. (This does not have to be the case.  It is perfectly possible to provide that all shareholders have the opportunity to acquire shares pro-rata to existing shareholdings for example.) If the largest shareholder refuses, to the second largest shareholder, and so on. The skill is in ensuring that all shareholders are happy with the position. A minority shareholder should always look to protect their rights.
• Employee shareholders with small percentages of shares - Working out fair value includes deciding if there is to be a discount where the shareholder leaver controls a minority shareholding.  Small shareholdings are worth less than large shareholders due to the lack of influence over shareholder voting.  Life is clearer if the agreement sets out whether discounts can be applied.

Solutions to shareholder leaver risks

The solution is to have bespoke corporate documents that cater for shareholder leavers. The documentation does not necessarily have to be complicated.  But, it does have to be in place before the shareholder leaves.  Documentation provides a framework for avoiding shareholder disputes, including :-

• Good leavers and bad leavers - The company needs a shareholders’ agreement that includes the concept of “leavers”.  Leavers are typically shareholders who have been directors or employees of a company but have left their respective positions.  Leavers can be drafted to mean whatever is needed to suit the parties intentions – there is no restriction on the definition of a leaver. Options include good leavers being allowed to keep their shares, requiring them to sell them back to the company or directors can be left to decide how the shares held by the leaver will be dealt with at the time of leaving or for total fairness the decision can be left to an independent expert. There are many other options, we can advise you on the best for you.
• Ability to pay shareholder leavers in instalments - There may be circumstances where it is appropriate to stage the payments in instalments.  The obligation for the company to pay the installments can be subject to conditions. For example, to protect intellectual property, the company may only be obliged to continue instalments if the seller is not working in competition. Another common condition is the seller’s continued compliance with restrictive covenants.