So you’ve decided you want to implement a share scheme for your employees. What happens if one of them leaves? Obviously one of the reasons for implementing your share incentive may be to avoid this scenario but sometimes things happen that you cannot pre-empt.

First it is important to understand the legal distinction between an option-holder and a shareholder.

Options

You’ll need to make it clear if there is a period of time during which your employee holds options (i.e. the right to acquire shares at some point in the future) as opposed to immediately acquiring shares. During this time the employee is not (yet!) a shareholder.

Typically the legal mechanics are simple when it comes to employees who hold options (and not shares) when they leave; the options can simply lapse and fall away. You may want to have the discretion to allow someone to exercise their options if they leave (for example if they have been with the business for a long time and leave for reasons of ill-health). The legislation for certain types of share option allows a period of 90 days in which a former employee can exercise their options without losing any of the tax advantages. After this 90 day period the tax costs can be become complicated, so it is usual practice that options lapse automatically after 90 days.

In any event this works alongside one of the key purposes of the share incentive; rewards ceasing once the employee is no longer contributing to the success of the business.

Shares

When an employee becomes a shareholder the legal mechanics are very different if they were to leave your company.

Sometimes it may not be appropriate to have any form of buy-back on the shares, and we often see this being the case with start-up companies; everyone agrees that they have “earned” these shares (as often the salary level and other benefits are considerably lower in early-stage businesses).

In more mature businesses, with succession planning forming part of the thinking behind the employee share scheme, it is generally appropriate for the shares to be linked to ongoing employment. You would then expect to see provisions in the Articles of Association of the company providing that if they leave they are “deemed” to have transferred the shares if the company so decides (typically through a buy-back arrangement after which the shares can be cancelled).

Good/Bad Leaver

If buy-back provisions are to be included you could decide to go further and make the distinction between “good” and “bad” leavers. Good leavers usually expect to be paid the fair market (or asset) value for their shares with bad leavers only receiving the price paid or a nominal sum.

Bad leaver triggers can often include things such as being in breach of any restrictive covenants in an employment contract after leaving or being dismissed for gross negligence or misconduct.

Keeping things simple is the best way to approach these provisions whilst being consistent with having a balanced reward for your team. Overly complicated buy-back triggers can cause confusion.

Legal Mechanics

If you provide, in the Articles of Association, that the company shall have the right of first refusal on any buy-back of shares when an employee leaves this means that the other shareholders do not need to find the cash to pay for them themselves.

Should the company not be able to complete the buy-back (for example if there are insufficient reserves) then an employee benefit trust could be established to facilitate this. An employee benefit trust could borrow the cash (from the company) and then “warehouse” the shares it purchases ready to issue them to other employees whose share options may be exercised in the future.

To give the board some discretion over the timing and enforcement of the buy-back provisions automatic buy-backs should be avoided.  Instead give your company a period (for example 12 or perhaps 18 months) in which it has the option to trigger the buy-back.

For further information on employee share schemes, please do not hesitate to contact an Everyman Legal Solicitor on 01993 893620 or email everyman@everymanlegal.com