The decision to bring on board venture capital funding is a huge moment in any start-up's journey. Not only does it provide access to funds and professional expertise to accelerate growth, but it also represents an external validation of the company's potential. However, with third party investment comes, inevitably, some degree of responsibility to investors – founders will likely find themselves subject to (amongst other things) covenants as to how the business is run and undertakings as to what they can do with their shares going forward.
In the first of a series of blogs aimed at demystifying common provisions found in venture capital term sheets (with the hope of accelerating the negotiation process between investors and founders), Peter Sugden discusses "good leaver / bad leaver" provisions in early-stage venture capital investment.
What are good leaver / bad leaver provisions?
Good leaver / bad leaver provisions are clauses (usually found in the Articles of Association of a company) which oblige an employee or founder shareholder to transfer his/her shares if he/she leaves the company (ie. becomes a "leaver"). The price at which that transfer takes place will generally be determined by whether the leaver is a "good leaver" or a "bad leaver".
Why are they commonly found in venture capital investments?
Early-stage investment is fundamentally based around good ideas and the people who have those ideas. Founders and key employees are often the key assets underpinning a decision by a venture capitalist to invest. As a result, a key part of venture capital investment is ensuring that the company's executive team are properly incentivised to develop the business following a fundraise – this will help to align the interests of the founders with the interests of the investors. Bill T. Gross (the founder of the US start-up studio Idealab) said in his 2015 TED talk: "If you take a group of people with the right equity incentives and organise them in a start up, you can unlock human potential in a way never before possible." The promotion of good behaviour in an executive team through equity incentives is an important part of a venture capital investor's strategy. Good leaver / bad leaver provisions play a key role in this by:
- incentivising executives to stay with (or, frankly, deterring them from leaving) a business by requiring them to transfer their equity in the company if they leave;
- preventing leavers from profiting from the capital growth of a business to which they are no longer contributing; and
- providing a pool of shares (ie. the shares transferred from the leaver) to allow the business to recruit a replacement for the leaver and incentivise that individual properly.
Who decides if someone is a good leaver or a bad leaver?
This is a key point of negotiation between the founders and the investors and will be based on the reason for which the founder/employee leaves the business. Given that good leaver / bad leaver provisions seek to encourage good behaviour amongst an executive team, in general a "good leaver" will be a leaver who leaves the business for reasons beyond their control, while a "bad leaver" will be a leaver who leaves the business voluntarily or because they have done something which is wrong or damaging to the business. Common examples of each are:
Dismissal for cause, including:
Permanent incapacity (either personally or of a dependent)
Retirement (at normal retirement age)
Voluntary resignation (save in circumstances which constitute wrongful or constructive dismissal)
Wrongful or constructive dismissal
Any reason for leaving which does not result in the leaver being a "good leaver"
It is increasingly common in venture capital transactions for a less binary distinction to be drawn between being a "good" and a "bad" leaver by also having a concept of an "intermediate leaver" – this often applies to scenarios such as voluntary resignation after an agreed period of service or unfair dismissal, where the "bad" leaver tag is sometimes seen as less appropriate.
Why does it matter if someone is a good leaver or a bad leaver?
The distinction between being a good leaver and a bad leaver is significant as it will determine the price to be paid for the transfer of the employee/founder shareholder's shares. The most common position is for:
- a good leaver to be paid fair market value for his/her shares; and
- a bad leaver to be paid the lower of fair market value and nominal value for his/her shares.
Where the concept of an intermediate leaver is used, a portion of the leaver's shares are often purchased for fair market value, with the remainder being purchased at the lower of fair market value and nominal value.
Fair market value in these cases will usually be a price agreed between the leaver and the board of directors of the company, or – if they can't agree – as determined by an expert using a pre-agreed valuation methodology.
A recent high-profile example (albeit outside of the venture capital context) of the value of being treated as a good leaver was the departure of Martin Sorrell from the advertising giant WPP. It was widely reported in the press that Mr Sorrell left WPP as a "good leaver" which entitled him to an exit package of around £15m, a fact that led to shareholder revolt at the company's most recent Annual General Meeting.
Some points of practice for investors and founders
Good leaver / bad leaver provisions extend their roots into some deeply personal elements of a founder's personal life – retirement, health and plans for where life might take him/her generally. It is key that founders engage with the possible personal reasons why they might leave a business at an early stage in a fundraise. For example, if a founder wishes to retire early within a few years of the fundraise or simply has other interests that he/she wishes to pursue in the medium- or long-term then he/she might be able to agree with the investor that his/her voluntary resignation after a pre-agreed period of time should not be a bad leaver event (and should instead be a good or intermediate leaver event).
Investors, meanwhile, need to ensure that the good leaver / bad leaver provisions which they negotiate with founders are enforceable when needed. One complicating factor here is the general principle of English law that penalty clauses are unenforceable. There is, therefore, an important line to tread when drafting bad leaver provisions to ensure that they do not represent a punitive remedy against a leaver (on the grounds that shares are commonly required to be transferred at significantly less than market value in this scenario). Recent case law suggests that being able to demonstrate that founders received independent legal advice prior to entering into an investment with a venture capital investor is important to show that bad leaver provisions are proportionate and in the legitimate interests of the company and investor, both of which are key considerations in determining enforceability. Alarm bells should ring if founders don't propose to appoint appropriate advisers.