GOOD LEAVER/BAD LEAVER PROVISIONS
Authored by: Sameer Huda and Marisa Finnerty
In private equity transactions, an institutional investor will generally seek to acquire a stake in a target and retain the management team to continue to run the business. In the event that an owner manager subsequently resigns from the target, an institutional investor will often want to have the right to a call option over that owner manager’s shares, in favour of either the company or the institutional investor itself. This call option will need to be included in the shareholders agreement and also the articles of the target to be enforceable with respect to the target itself. It would generally be exercisable upon the termination of the owner manager’s employment.
If a call option is exercised by the company or the institutional investor, the circumstances of the departure of the owner manager would usually dictate the price to be paid for his shares and the method by which this is paid.
The statutory pre-emption provisions set out in the UAE Companies Law mean that enforceable call options need to be structured in other “offshore” vehicles. Fortunately, there are always a range of solutions to this issue which can be used depending on the specific deal. In this article, we consider the concept of persons deemed as “good leaver” and “bad leaver” in the context of owner managers exiting a target, including how these are dealt with under a typical shareholders agreement as regards the valuation of their shares and the terms of payment of the share price.
The typical definition of “good leaver” would include the following circumstances:
- Termination of the employment of the owner manager other than for a material breach of his employment contract.
- Resignation by the owner manager of his employment for specific reasons such as: (i) a material reduction in the compensation of the owner manager; (ii) a material reduction in the responsibilities of the owner manager; or (iii) a material breach by the company of the terms of owner manager’s employment contract.
- The death or incapacity of the owner manager.
- The retirement of the owner manager at an agreed age.
- The owner manager is otherwise determined by the institutional investor to be a “good leaver”.
In any case, the term good leaver could be defined as broadly as an owner manager who is not a bad leaver (see below) or much more narrowly. An example of a narrow interpretation would be the death or incapacity of the owner manager or the owner manager being deemed a good leaver at the discretion of the institutional investor.
It is obviously also critical that the terms of the employment contract of the owner manager are considered fully by all parties and are consistent with the terms of the shareholders agreement to prevent ambiguity at a later stage.
The typical definition of a bad leaver would include the following circumstances:
- Termination of the employment of the owner manager for a material breach of his employment contract.
- The owner manager resigns from employment for reasons other than those specifically agreed with the institutional investor as enabling him to be deemed a good leaver as set out in the shareholders agreement.
- The owner manager breaches specific restrictive covenants included in the shareholders agreement.
As with the definition of good leaver, the scope of the definition of bad leaver could vary depending on how the transaction is negotiated. For example, the definition of bad leaver could simply be defined as an owner manager who is not a good leaver. In addition, we have also acted in transactions where the definition of bad leaver is separated into different tiers (e.g. “ordinary bad leaver” and “extraordinary bad leaver”) where certain circumstances of departure are considered to be more detrimental to the business than others. For example, a person may be considered to be a bad leaver for breaching a material term of his employment contract but within the umbrella of bad leaver would fall under the sub-category of extraordinary bad leaver in the event that he: (i) is convicted of a serious crime; (ii) embezzles or misappropriates funds or property of the company; (iii) takes actions that will bring the company or the institutional investor into serious disrepute; or (iv) resigns from his employment within a particularly short period of time.
Valuation of Shares
The purchase price for the shares of a good leaver would typically be the fair market value of such shares on the date of termination of the owner manager’s employment with the target. Of course the method for calculating the fair market value of shares is in itself likely to be the subject of much negotiation between the parties, a full analysis of which goes beyond the scope of this article. However, the usual discussion points surround: (i) whether the valuation of the shares is determined by the board of directors of the company or by an external expert; (ii) whether the shares should be discounted on the basis of a minority shareholding; (iii) the specific accounting principles to be applied; (iv) whether the company should be valued on an asset or earnings basis; and (v) whether future earnings of the company should be taken into account.
The purchase price for the shares of a bad leaver would usually either be discounted by a certain percentage (for example, 75% of the fair market value of the shares), or deemed to be the lower of (i) the cost or nominal value of the shares at the time of execution of the shareholders agreement (in which case a reference to the specific amount should be included in the shareholders agreement); and (ii) a discounted percentage of the fair market value of the shares on the termination date of the owner manager’s employment with the company. In addition, in the event that the definition of bad leaver is divided into sub-categories (e.g. ordinary bad leaver and extraordinary bad leaver), then the valuation methodology attributed to the relevant shares would also vary depending on which sub-category is applied.
If the owner manager is a good leaver at the time that the call option is exercised, then the purchase price for the shares would usually be paid in full and in cash on the date on which the shares are transferred. However, even if a managing shareholder is determined to be a good leaver at the time of exiting the company, a certain amount of the purchase price may be withheld by the company/institutional investor in order to cover situations where a good leaver subsequently becomes a bad leaver (for example, if a good leaver breaches restrictive covenants following his exit from the company or is subsequently discovered to be a bad leaver for reasons which were not known at the time of his departure). In addition, it is not uncommon for a payment to a good leaver to be staged over a certain period to assist the cash flow position of the payer. All of these situations need to be considered in drafting the relevant definitions and clauses.
If the owner manager is a bad leaver at the time that the call option is exercised, then the majority of the purchase price may be withheld by the company/institutional investor until the earlier of: (i) the institutional investor disposing of a substantial portion of its shareholding; (ii) completion by the company of an IPO; or (iii) the expiry of a certain period of time from the date on which the shares are transferred by the owner manager (in which case staged rather than a single bullet payment are generally used). Again the provisions regarding payment of the price for the shares may vary further between ordinary bad leaver and extraordinary bad leaver if these sub-categories apply.
The provisions of a shareholders agreement relating to good leaver and bad leaver tend to vary considerably depending on the importance and level of thoroughness generally exerted in this area by an institutional investor. Discussions on these provisions can incur more time than might be generally expected as the issues raised are sensitive as they affect the owner manager on a personal level. However, by spending sufficient time at the outset of the transaction, considering, negotiating and clearly documenting the agreed position on difficult points relating to the departure of an owner manager, as well as the various options that can be employed to address this type of issue, parties decrease their likelihood of a protracted dispute in the future or of mismanaged and misunderstood expectations.
This article, including any advice, commentary or recommendation herein, is provided on a complimentary basis without consideration of any specific objectives, circumstances or facts. It reflects the views of the writer which may, in some cases, differ from those of the firm, especially in the develop jurisdiction of the UAE