A company can issue shares to investors in return for a cash injection or as an incentive for founders, employees and contractors (referred to as ‘non-investor’ shareholders). Shares are most commonly subject to good/bad leaver, or vesting provisions where the shareholder is a non-investor.
The purpose of these provisions is to restrict the circumstances under which a shareholder can keep their shares. For instance, a four-year vesting period means an employee is entitled to all their shares if they work for your business for four years. If the employee resigns, you would want them to sell the shares they haven’t earned back to your company.
You can achieve this by either having the shares subject to:
- leaver provisions,
- vesting provisions; or
- both leaver and vesting provisions.
Your company’s shareholders’ agreement should set out what happens to a shareholding when a good or bad leaver event occurs.
The circumstances in which a shareholder leaves will determine how much your company pays for their shares. We discuss the circumstances in more detail below.
Usually, a shareholder must sell their shares back to either:
- the remaining shareholders pro rata (i.e. each shareholder can purchase the number of shares equal to their percentage ownership in the company),
- the company; or
- an entity nominated by the company.
Good Leaver Events
Where a good leaver event occurs, the sale price is most commonly the fair market value of the shares. Good leaver provisions are a way to ensure that the company does not have to deal with shareholders who no longer have any involvement with the company.
Bad Leaver Events
A bad leaver event usually involves an element of ‘fault’ on behalf of the shareholder, for instance:
- a shareholder resigns within the first year of the company granting them shares; or
- the company lawfully terminates (i.e. fires) the shareholder. You can specify the reasons for termination, for example, the shareholder commits fraud or a criminal offence, or breaches their employment agreement.
If a bad leaver event occurs, the company can penalise the shareholder by imposing a discount on the sale price. For example, the shareholder may only receive 80% of the fair market value of their shares (a 20% discount). Bad leaver provisions can often deter shareholders from leaving the company.
Vesting helps motivate key team members to stay with your business and prevents your company having ‘stale shares’ on its cap table. For example, a founder who has left the business still owns 40% of the shares.
The company will initially issue the shares to the shareholder upfront. But, if the shareholder leaves, they can only keep their shares if they hit the prescribed milestones.
Practically, a co-founder will receive nothing if they leave the company before the first year has passed. At the one year mark, 25% of the shares will vest and then, from that point onwards, the remaining 75% will vest annually, quarterly or monthly. If a shareholder left after two years, they could keep 50% of the shares, and must then sell their non-vesting shares back to the company for a nominal value (often $1).
Investors typically require that the startup founders’ shares are subject to vesting to ensure they are committed to the business.
Employees who are granted shares or options under an employee share plan will also be subject to time-based vesting as an incentive to remain with the company.
In some circumstances, performance-based vesting may be more suitable as an incentive to see results. For example, it is impractical for a HR consultant who contributes ad-hoc services to your startup over several months to have their shares vest over time. Instead, you might provide that 25% of shares will vest each time the consultant hires ten employees who remain with the business for six months.
A shareholder must sell the unvested shares back to the startup if they leave before meeting the performance criteria, or if they don’t meet the criteria in a specified period.
Performance-based milestones are difficult to set out upfront. Returning to our HR consultant, what if they move into a different role at the company, and you hire a recruiter? This is why time-based vesting is more common.
Both Leaver and Vesting
Sometimes, a company might subject shareholders to both vesting and leaver provisions. This means that even if the shares have vested, the shareholder would still have to sell back their shares if they left the business. Some companies do this because they don’t want shareholders who are former employees voting in decisions that affect the company. Buying back shares can also help manage the cap table, which becomes more complex with new hires and additional funding rounds.
A shareholder might view this as unfair, especially if good leaver provisions apply. In this situation, the shareholder has earned their shares through vesting and has left on good terms, but are forced to sell their shares back to the company at fair market value. A shareholder may, instead, want to retain their shares and participate in a future exit event (e.g. a business sale) or sell after the share price has increased.
When deciding whether to include both vesting and bad leaver provisions, you should consider:
- Who you’re issuing shares to, and whether you would work with them as a shareholder after they leave the business; and
- What your shareholders would find fair and reasonable. For instance, a shareholder may feel entitled to choose how they deal with the shares they have earned while working for the business.
If the shareholder is a bad leaver, the company may wish to cut ties with the shareholder to avoid any future difficulties. This may also prevent existing employees, who may also be shareholders, resenting having to work on increasing a company’s value for shareholders who have departed.
A company should carefully consider issuing shares to its co-founders, employees, consultants and advisors. Your shareholders’ agreement should set out what happens to their shares when they leave. Leaver and vesting provisions can help motivate a shareholder working for your company, and deter bad behaviour.
Although it’s best practice to have these conditions agreed upon when the shareholder joins the team, you can include these terms in your shareholders’ agreement after it’s drafted. For instance, introducing founder vesting provisions before you raise capital to attract investors).
If you need help drafting your shareholders’ agreement or have any questions about incentivising your team members, get in touch with our startup lawyers on 1300 544 755.
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