Once you have considered a share incentive for your employees you will need to think about what happens if one of the employees to whom an award has been made leaves your business. Generally business owners want to restrict ownership so that there is a mechanism to ensure that a leaver does not take their shares with them. We begin with an important distinction (that sometimes causes confusion) and then set out the options available to you.
Options versus Shares: Leaver Provisions
If your share incentive is structured through a share option (rather than an immediate share acquisition) then it is important to distinguish between the period of time when your employee is an option holder (i.e. has the right to acquire shares) and the time from which they become a shareholder (i.e. after they have exercised their share option).
For those awarding EMI options to employees there is no statutory imperative to distinguish between good and bad leavers. Generally it will be better and simpler to specify that all options lapse when an employee leaves for any reason. The only question then is whether you allow a small window of time for the ex-employee to exercise their option. The EMI legislations allows a period of 90 days during which a former employee can exercise their EMI option without adverse tax consequences. After that 90 day period the option gain becomes liable to income tax (or PAYE if at exercise the company is about to be sold). To avoid the need to agree a value with HMRC in order to assess and manage the PAYE cost on exit, it is usual practice to provide for options to lapse beyond the 90 day period. This fits in with the philosophy of rewards ceasing once the employee is no longer contributing to your Company’s growth.
Buy-back of Leaver Shares
So your employees have acquired shares in your company and are now to leave: what legal framework is appropriate in these circumstances?
You might be content for them to keep their shares and enjoy dividends, voting rights and capital growth. With start-up and early stage companies this is not an unusual scenario for the company’s founders. Everyone may agree they have “earned” their shares. For those who acquire shares in a more mature company it is generally accepted that their share rewards should be linked to their ongoing employment so if they leave, their shares should be subject to buy-back at the option of the company. Invariably this will be a one-way option, a call option for the company and its continuing shareholders.
Good/Bad Leaver
On the assumption that shares are to be subject to a compulsory buy-back you must then decide if you want to distinguish between good and bad leavers. Good leavers will generally be paid Fair Value for their shares and Bad Leavers much less or a nominal sum. Often owners will take the view that if an employee breaches post termination non-competition provisions (or is dismissed for gross misconduct) his shares should be forfeited. Generally you will want to choose as simple a regime as possible consistent with having a fair, and thereby attractive and motivational, share incentive.
Valuation Me
thodology
Your Articles will need to specify how the shares of a leaver are to be valued, at least if they are good leavers. You will generally want to specify that the valuer should be the company’s auditors or a firm of accountants nominated by the Directors. Where the Articles are silent on the subject a valuer will typically apply a significant discount to a minority shareholding under general valuation principles. This could be a discount of as much as 75% reflecting the fact that a minority interest has little power and influence. Often it is felt fair to specify that no minority discount should be applied.
Where employees hold a different class of shares with no dividend or voting rights this will affect their value. Remember though that using such shares may make the scheme less attractive (or appear less attractive) to your team.
Buy-Back Mechanics
It is generally a good idea to include (within the Articles) the right for your company to be the prospective buyer of the shares of a leaver. That way you do not have to take money out of your company (paying tax on it) before you buy back the shares personally.
Should the company not be able to undertake the buy-back (e.g. because there are not sufficient distributable reserves) then an alternative could be a buy-back through an employee benefit trust. Such a trust could borrow money from your company and warehouse the leaver’s shares perhaps pending an EMI option exercise from a new employee.
You will want to be in control of the buy-back process and timetable. So it is best to avoid automatic buy-back Articles. Instead give your company a period, typically 12 months, so that you can manage the process. By stipulating for such a period you can also police any post termination non-competition undertakings which might (see above) trigger a buy-back at nominal value for the shares of a bad leaver.
Leaver Provisions in Articles of Association: Can they be inserted retrospectively?
The expected retort might be “why not”, if the other shareholders can pass a special resolution why should they not simply change the Articles and incorporate a buy-back provision? Here are the reasons this may not be possible:-
- Change must be bona fide for the benefit of the company as a whole
The shareholders must be able to demonstrate (if challenged) that the change is bona fide for the benefit of the company. But the obvious question to be put to them will be why propose a change now. If the buy-back provision is clearly targeted at the leaver, rather than being for the general good it will raise a significant suspicion.
- Need for a class consent
Where there are different classes of shares with different rights a change to the Articles may require a class consent. If the leaver has more than 25% of one class of share, he or she may be able to block the change.
- Moving too slowly…..
Leaver provisions are invariably triggered where an employee-shareholder ceases to be employed. But what if the horse has already bolted? Could what might otherwise be a fair buy-back be extended so as to cover the shares of someone who left before the new Article was adopted? That would seem much more likely to be the victimisation of a single leaver not an Article for the common good.
- Unfair prejudice legal claim
If a majority changes the Articles with a view to disadvantaging a minority shareholder this may give that shareholder a right to claim unfair prejudice. For the minority shareholder this could give them a significant advantage. If they win on such a claim then the other shareholders or the company could be required to buy shares at fair value. The valuation may well exclude a minority discount.
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
