Leaver Arrangements, Shareholders and Employment Agreements and Vesting Options

Companies and businesses face numerous challenges in their growth trajectory which include capitalization, funding requirements, management, vision, talent retention, investor interest etc. For new and start-ups securing investor backing indicates potential, growth and stability and to a degree endorsement of their venture.

Most investors look at investment opportunities directly proportionate to the accountability, commitment and abilities of the founder/promoters/ core (“Promoting Core Team”) towards the company and the business. It is, therefore, a standard practice for investors to impose commitment obligations on the Promoting Core Team through covenants in the Shareholder’s Agreement and Employment Contracts and Articles of Association to secure business growth, deter premature promoter exits and profitable price valuations.

The “Good Leaver/Bad Leaver” provision is an efficient tool to make businesses grow and retain commitment of Promoting Core Team.

In fact there is a jurisdictional aspect to Leaver and Vesting arrangements

What is a Good Leaver/Bad Leaver clause?

Very simply put, Good Leaver and Bad Leaver flow from breach and non-breach outcomes of a relationship. The implication of the outcomes are linked to ownership of equity shares and price determined for such equity shares at the time of exit from the Company/ business by the members of the Promoting Core Team.

  • A committed staying member receives the value of the equity shares he/she owns; and
  • A premature or breach exit of a member (voluntarily or dismissal) does not receive the full value/ any value of the equity shares he/she owns.

The share price/ value for the equity is either full Fair Market Value or significantly discounted from the Fair Market Value based on “Good” or “Bad” leaver.

Objective of Good/Bad Leaver Clause

The underlying principles of introducing a Good Leaver/ Bad Leaver concept-

  • to create exercisable and enforceable contractual rights at the hands of an investor or inter se among the other Promoting Core Team;
  • to retain value of the Company and business;
  • to deter Promoting Core Team from exiting the Company/ business prematurely (sometimes also referred to as Early Leaver) and frustrating/ eroding growth and value.

*In a side research conducted by INSEAD, it was found that majority of Start-ups fail not due to poor product but due to inter-personal Founding Core Team issues.  

Who is a “Good” and “Bad” Leaver?

ConditionGood LeaverBad Leaver
Death 
Permanent Disability/Incapacity/ Ill-health 
Retrenchment / Redundancy 
Exiting due to fulfilment of the Agreement 
Retirement 
Resignation on good terms 
Breach of the Terms of the Shareholders or employment Agreement or both 
Breach of any governing law resulting/ requiring dismissal 
Wilful negligence, fraud, misconduct 
Voluntary resignation by member before completion of lock-in periods/ business targets 
Resignation on bad terms 

Note: Bad Leaver obligations cannot be imposed indefinitely, typically they linked to either a fixed number of years, achievement of critical targets or liquidation event.

Determination of Price and Value

Determining price of shares in a private company is difficult and subjective.

Pre-Money valuation can include an agreed pricing mechanism/ formula in the Shareholder’s Agreement. This can be based on some projected business plans and targets. Typically, this would assist investors to ascertain investment horizons.

Equity shares held/ owned by Good Leaver are sold at FMV. The purchase price for equity held by Good Leaver is paid in full and many times instantaneously. However, in certain circumstances, it may be withheld till an appropriate liquidity event, this may have to be contractually recorded.

Equity shares held/ owned by Bad Leaver would not be sold/ transferred at the FMV.

They would be transferred at a pre-agreed considerably discounted / lower price, sometimes based on the offence, it could also be transferred at INR 1/- (eg. 25% or 50% of the FMV on the date of resignation, breach or exit) or Book Value or any other nominal value.

The purchase price for Bad Leaver is paid in full and instantaneously. The Tax implications vary and jurisprudence on the same differs.   

If for a Bad Leaver, the existing shareholder’s do not invoke the rights receiving such shares (as per call option rights, then the onus can be on company to buy back the shares. Insufficiency of funds at the Company’s hands, could require a sale to any third-party/ investor subject to the first refusal rights in the Shareholders Agreement.

Enforcing Good Leaver/Bad Leaver provisions

These clauses are heavily negotiated and require extreme skill and caution in drafting. The Shareholder’s Agreement is a mutually exclusive with other documents such as Articles of Association, Employment Contracts and Director Service Contracts etc. 

While the Contracts capturing Leaver Arrangements are mutually exclusive in terms of occurrence of events, they become cumulative in effect of the events. A trigger under one document is normally treated as the First Trigger and under multiple, can be the Second and the Third Triggers.

All these documents need to be low on interpretational conflict especially with Employment Contract. Employment and Labour laws of a particular jurisdiction can have potential implications on termination of employment, breach scenarios etc. which need to be separated from voluntary resignations. Any treatment of exiting executive under a Bad Leaver situation which is not provisioned in the Employment Contract is potentially open to challenge as unfair treatment or unfair dismissal. Penalties under contracts are not viewed favourably by most courts thus, the Bad Leaver provisions need to be drafted in a manner where the compulsory transfer is a primary obligation and is not by way of a penalty.

Enforceable Contractual Rights

A Good Leaver and Bad Leaver provisions have to be included in Shareholders Agreement, Employment Agreement and the Articles of Association.

Sample clause for Employment Agreement:

“If (i) the Employee’s  Termination is the result of by the way of Cause or;(ii) the Employee’s Termination  is without good reason resulting in a Bad Leaver  or (iii) the Executive materially breaches any of the covenants of this Agreement  which is not cured within 15 days of written notice from the Company or the Company becomes aware of the Employee’s willful breach of any of the covenants (a “Covenant Breach”) then on or after the Employee’s Termination Date in the case of clause (i) & (ii) or on or after the Covenant Breach in the case of clause (ii), the Company or the existing shareholders may purchase all of the Shares held by the Employee in the Company at the Book Value.”

Sample clause for Shareholders Agreement:

Sample 1:

“If a Promoters service is terminated by the Company for Cause at any time or due to a breach of any of the terms of this Agreement, then all ESOP shares, whether vested or unvested, shall be automatically and immediately forfeited for no consideration. All Restricted Shares will be compulsorily transferred to the Company or its affiliates at the Company’s option at Book Value.”

In addition, the definition clause must define terms like “Cause”, “Good Leaver”, “Bad Leaver”, “Restricted Shares” and “Transfer Restrictions”. The next recommended step would be to amend the AoA and incorporate the provisions of the SHA because in case of conflict between the two the AoA shall prevail[1].

Treatment of Leaver’s shares

Bad Leaver’s shares may be:

  1. Compulsory transfer to the company at book value/ par value/ allotment price. To implement this the Company may have to conduct a Buy Back to effectuate this; or
  • Transferred to the existing shareholders at a predetermined price normally lower than Fair Market Value / can be as low as Rs. 1 in case of fraud; or
  • Transferred to the ESOP pool (unvested ESOPs which are lapsed); or
  • Forfeited by the Company.

Buy-Back

Company law is prescriptive about buy-back provisions, section 68 of the Companies Act, 2013, Buy Back is when a company purchases it shares or other specified securities out of (i) its free reserves (ii) the securities premium account (iii) the proceeds of the issue of any shares or other specified securities.

Buy Back must be authorized by the Articles of the Company;

Company must pass a Special Resolution to authorise this Buy Back;

However, a buy-back up to 10% of the total paid-up equity capital and from free reserves of the company may be authorised under a Board Resolution.

Buy-back cannot exceed 25% the aggregate paid up capital and free reserves of the company in any financial year;

The ratio of the aggregate secured, and unsecured debts owed by the company must not be more than twice of its paid capital and free reserves at the time of the Buy-back.

To be completed within a period of one year from the date of passing the special resolution/board resolution.

Where a company completes a buy-back of its shares and other specified securities, it shall not make any further issue of the same kind of shares including by way of rights of other specified securities within a period of six months. However, shares may be issued by way bonus issue or conversion of warrants, stock option, preference shares/debentures (subsisting obligations on the company).

Buy-back results in reduction of share capital for the shares to be held in treasury or cancelled.

Fair Market Value

Fair market value is the price agreed between a buyer and a seller for a specific asset. 

Various provisions under the Companies Act, 2013 provide for issue/ sale/transfer of the shares at the Fair Market Value determined by the Registered Valuer along with justification for the same.

Determination of Fair Market Value in case of transfer of shares:

When owner of Shares in a privately held Company transfers the shares to any person, he is required to pay Capital Gain tax on the difference between the sale consideration received by him and the cost of acquisition of such shares (or the inflation indexed cost, wherever applicable)

As per rule 11UA of the Income Tax Rules, 1962, this sale consideration should be at least equal to or more than Fair Market Value.

The Fair Market Value is determined by the Registered Valuer or the Merchant Banker as may be applicable. However, if its equity shares of an unlisted privately held company, then rule 11UA(1) of the Income Tax Rules 1962 (in terms of section 56  of the Income Tax Act i.e. income from other sources), to determine the value of property other than immovable property will apply.

The rule states:

fair market value of unquoted shares and securities other than equity share in a company which are not listed in any RSE shall be estimated to be price it would fetch if sold in the open market on the valuation date and the assessee may obtain a report from a merchant banker or an accountant in respect of which such valuation.”

ESOP and Call Option Right

The Promoter shares are subject to a Reverse Vesting – the shares are available at a repurchase option at the discretion of the Company. The Price at which these shares are called upon are normally, either the original purchase price or the FMV, the lower of the two.

The Vesting arrangements normally have a one year “cliff” and a vesting period of 4-5 years. In case of a Good Leaver, the vesting is accelerated and in case of a Bad Leaver they lapse, could be quarterly or half yearly or even yearly. The essence being, if the investor has invested at a pre-money valuation to acquire shares, then the promoters/ founders should work and take it  the valuation up to

A Call Option Right is a right incorporated in financial contracts which entrusts a right but not an obligation on the option holder to purchase the shares upon happening of a specified event or time.

Tax

Buy Back- The company is liable to pay tax at the rate of 20% + 12%(surcharge) + applicable cess on distributed income in case of Buy Back under section 115QA of the Income Tax Act, 1961.

However, in case a Company conducts buy-back of the shares at a price lower than FMV or at book value it would not incur any tax on differential value (which is chargeable section 56(2) (x) of Income tax At, 1961)

For the purpose of taxing buy-back under section 56(2) of the Income Tax Act, 1961, shares should become “property” of recipient-company whereas in case of buy-back, such shares are mandatorily cancelled and cannot become property of a company. Accordingly, buy back of shares should be out of the ambit of section 56(2) of the Act ( Case :Vora Financial Services P. Ltd. [2018] 171 ITD 646 (Mum))

Transfer between shareholders

When an owner of shares in a Company transfers the shares to any person, payment of  Capital Gain tax on the difference between the sale consideration received and the cost of acquisition ( along with indexation benefit) of such shares is required to be paid.

Forfeiture

Forfeited share application money is treated as a capital receipt and therefore it is not taxable in the hands of the company (case: DCIT vs  Vs Mahalaxmi Rubtech Ltd. (ITAT Ahmedabad)


[1]  Vodafone International Holdings BV v. Union of India (2012) 6 SCC 613

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