The Good, the Bad and the Ugly

An article on ‘Good Leaver’ and ‘Bad Leaver’ provisions in Shareholders’ Agreements

A Shareholders’ Agreement is a crucial document that outlines the rights and responsibilities of shareholders (and at times directors) within the subject company. It helps to establish a framework for decision-making, management, growth and disputes of the company and its business.

‘Good Leaver’ and ‘Bad Leaver’ provisions incorporated into a Shareholders’ Agreement aim to address the circumstances under which a shareholder may exit the company (especially in circumstances where the shareholder is also an employee of the company) and the impact of such an exit on the company and the remaining shareholders. The two terms (‘Good Leaver’ v ‘Bad Leaver’) are dealt with differently depending on the manner and circumstances in which the relevant shareholder exits (or wishes to exit) the company.

‘Good Leavers’ and ‘Bad Leavers’ can be defined by events or actions as broadly or as narrowly as the shareholders elect. Often the two concepts are defined in binary fashion, ie such that a ‘Good Leaver’ event may be defined as “an event that is not a Bad Leaver Event”. Terms such as “Good Leaver”, “Bad Leaver”, “Early Leaver”, “Shareholder Event of Default” and “Penalised Leaver” could be indicators of ‘Good Leaver’ and ‘Bad Leaver’ provisions in the document in question.

‘Good Leaver’ events are usually drafted broadly in Shareholders’ Agreements and consist of events that are outside the departing shareholder’s control, do not cause harm to the company and/or are considered favourable exits from the company. The provisions normally apply to both the departing shareholder and any directors of the company who are appointees of that shareholder.

‘Good Leaver’ provisions are designed to protect the departing shareholder’s interests and ensure the fair treatment of that shareholder exiting the company under “good” circumstances.

Examples of “Good Leaver’ events could include:

• death
• becoming incapacitated due to illness or injury
• voluntary resignation for good reason
• retirement (at normal retirement age or as stipulated in the Shareholders’ Agreement)
• termination in circumstances where the employee is not at fault
• redundancy
• unfair dismissal
• constructive dismissal

‘Bad Leaver’ events are usually drafted narrowly in Shareholders’ Agreements as they involve onerous consequences and consist of events where the departing shareholder is at fault and causes (or could cause) harm to the company. Once again, the provisions normally apply to the departing shareholder and its appointed directors in the company.

‘Bad Leaver’ provisions are designed to protect the interests of the remaining shareholders by imposing consequences on the departing shareholder for its actions. They aim to incentivise an employee from leaving employment and also from acting in a “bad” manner. The incentive is one of avoidance of loss.

Examples of “Bad Leaver’ events could include:

• jeopardising the reputation of the company and its business
• placing the other directors, remaining shareholders and the business into disrepute
• disposing of shares contrary to the Shareholders’ Agreement
• sharing trade secrets
• voluntary resignation without good reason
• material breach of the Shareholders’ Agreement or relevant employment or consulting agreement
• termination for cause
• committing fraud or an indictable offence
• breaching any restraint of trade provisions
• exiting the company within an initial minimum period (as agreed) for any reason whatsoever
• suffering an insolvency event
• disqualification to act as a director of a company
• failing to achieve certain targets (KPIs)

If either a ‘Good Leaver’ event or a ‘Bad Leaver’ event occurs, the shareholder the subject of the event will (most likely) be required to sell its shares to the remaining shareholders (under pre-emptive right provisions) or to the company itself (under share buy-back provisions).  This helps maintain stability and continuity within the company while regulating the departing shareholder’s financial interests.

Normally, the shareholders will negotiate and agree on a share valuation methodology to be included in the Shareholders’ Agreement. This may include:

• fair market value
• pre-agreed formula
• independent valuation by a valuer, broker or other expert
• multiple of earnings

When a ‘Good Leaver’ event occurs, the departing shareholder will invariably receive value for its shares, which corresponds to the chosen valuation methodology. If a ‘Bad Leaver’ event occurs on the other hand, the departing shareholder may be subject to a penalty or reduction in value for its shares. The penalty or reduction in value serves as a deterrent for shareholders generally and discourages behaviours that could be detrimental to the company or the other shareholders.

‘Bad Leaver’ provisions and the penalties associated with such provisions can motivate founders and employees and deter behaviour that is harmful to the company. They can also be attractive to potential investors in the company.

‘Good Leaver’ and ‘Bad Leaver’ provisions both contribute to the continuity and stability of the company by offering clear guidelines on the exit process for shareholders and minimising disruptions to the company and its business. These provisions play an important role in establishing a fair and structured framework for shareholder exits and help strike a balance between having regard to the departing shareholder’s interests and safeguarding the continuity and stability of the company.

It is also suggested to include a power of attorney clause (in favour of the board of directors) in the Shareholders’ Agreement in order to enforce the departing shareholder’s obligations should it fail to comply with the Shareholders’ Agreement (for example, by refusing to sign a share transfer form when required to do so).

When finalising a Shareholders’ Agreement it is vital that proper care is taken in drafting appropriate ‘Good Leaver’ and ‘Bad Leaver’ provisions. Without these provisions, you may inadvertently encourage poor shareholder practice and jeopardise your business. Likewise, provisions that support leavers in the event of unfortunate circumstances will encourage trust between shareholders (especially employee shareholders).

With a fair and reasonable set of terms in place, the company can confidently move forward knowing its key employees are aligned and incentivised.

If you would like to know more or require a Shareholders’ Agreement for your company, please feel free to contact MPH Lawyers on (08) 9221 0033 or Henry van der Westhuizen at hwest@mphlawyers.com.au.