Disclaimer: this article is not intended to be legal advice, any agreements between a founder and an investor should be drafted and reviewed by a lawyer.
When we issue a terms sheet for a potential investment, it’s usually a happy occasion on both sides - we’re really excited about working with a new team, they’re excited to get the capital in so they can get to work, and we’re all focussed on our mission to decarbonise a new sector. There is sometimes some back-and-forth about valuations but generally we’re all aligned until… we get to discussing the leaver provisions.
‘Leaver provisions’ refer to the section of the legal documents which deal with how the Founder’s equity is treated in the event of a founder leaving. They are necessary, as without them there is nothing to force a compulsory transfer of shares by a shareholder, even if they have acted directly against the company’s interests. Few subjects have the ability to stoke up division between a founder and an investor in quite the same way. Both sides are trying to protect the business while respecting individual contributions, but getting the balance right can be very hard due to the different perspectives on each side.
The Leaver Provisions are usually homed in the Articles, and sometimes mirrored or referenced from the Shareholder’s Agreement. They typically include a definition of Good vs Bad leavers, trigger events and specify equity retention and valuation:
A ‘Bad Leaver’ is someone who, as the name suggests, leaves under bad circumstances - gross misconduct, fraud, dishonesty, or a criminal offence. This includes someone being dismissed or resigning under these circumstances.
The Bad Leaver clause may also include Leavers departing on any grounds which entitle the company to immediately terminate the Founder’s employment.
And here’s the controversial bit. Most investors also designate as ‘bad’ any Founder who resigns for any reason during the ‘Relevant Period’ (i.e. while their equity is vesting), except for conditions which could constitute a constructive dismissal.
A ‘Good Leaver’ is anyone leaving who isn’t a Bad Leaver.
Most docs also include a carve-out such that the board can redesignate a bad leaver as good at their discretion, and this is intended to cover circumstances under which a Founder needs to leave through no fault of their own - resignation due to health reasons, issues with dependants, company restructuring and so forth.
It’s worth noting that a Good Leaver can be redesignated as a Bad Leaver even after they leave the company if they breach their non-compete obligations under the Shareholder’s Agreement or their terms of employment.
Trigger events - these define when the provisions are activated, typically when the Founder ceases employment, but it can be when they give notice.
Equity retention and valuation - this part defines how the Founder’s equity is treated when they depart, which depends on the circumstances of departure and whether they are classified as Good or Bad leavers. We’re assuming that the Founder’s shares are subject to reverse vesting over a number of years, which is usually the case. For ‘good’ Founders, there will be a formula which defines precisely how much of the vested equity they can keep based on how many months they have served in the relevant period. They may have the option to transfer their shares, or sell their shares back to the business for a fair market value determined by an independent valuation. Usually, ‘bad’ Founders forfeit all their vested shares. They are usually converted into ‘Deferred Shares’ which are effectively worth nothing, or they may be bought back for a defined nominal value.
The BVCA has a set of model documents for deals which most investors will take as the starting point for any deal paperwork. They were reworked in 2023 to be more fair in line with evolving market norms. However, there are lots of tuneable options in brackets, so there are many permutations which could claim to be based on the model docs. This means they dodge the pivotal question of whether a Founder leaving the company voluntarily is a ‘bad’ one, as this is an option in square brackets. We’ve included the relevant parts of the standard language at the bottom of this article for reference. There are similar professional bodies in most countries, so check out their model documents if you are not in the UK.
Here are some of the learnings we’ve gained about reaching an amicable agreement over the leaver provisions:
Understand what is typical: We are currently in a tough “risk off” funding environment where most founders do not find themselves in a strong negotiating position. You may feel fortunate to have even one term sheet. Many VCs are adopting a more defensive position in many commercial areas, and leaver provisions are one of them. But, just because you may not have the luxury of multiple term sheets on the table, it doesn’t mean you have to accept whatever the VC is pushing for. Do get external advice if you think the terms are unreasonable - an experienced lawyer should be able to give perspective on whether suggested provisions are typical. Refer to the BVCA model documents which are generally taken as the starting point by most VCs.
Try to understand where the investor is coming from: Successful companies require years, sometimes decades, of dedication and sacrifice. At the beginning, it might be hard to imagine the company as a separate entity from the founding team - after all, it’s your idea, and your hard work is what has got it this far. You have to believe in yourself and be 100% committed to the journey. However, from incorporation, your first responsibility is to the best interests of the company, and you need to think about the major risks facing it and have a plan in place for them. One of the benefits that a VC can bring is an external perspective - it’s important to hear their thoughts about the risks to the company without taking them as a slight to you or the team, or as an indication that they are not equally committed to the success of your company.
Try on different hats: Most founders are thinking about the situation where they are the one leaving, through no fault of their own, potentially empty handed - and they think it would be unfair to have nothing for their years of sacrifice. But, try to imagine the situation where you are the one staying, and your co-founder is departing. You will probably need to hire or promote a replacement, and they need to be adequately incentivised. Later-stage investors want to see the active leaders of the company having a good level of ownership, and don’t want to see ‘dead equity’ on the cap table from a departed founder (see our thoughts about fixing cap table mistakes). You need to be able to retain enough equity to give your company the best chance of success in a range of different outcomes.
Reframe the problem - Consider using less emotive language. We like to use the term “Early Leaver” rather than “Bad Leaver”. Alternatively, you could consider having an intermediate class of leavers, for example “Good”, “Bad” and “Neutral”.
Get some perspective - if you are struggling to finalise terms, consulting a neutral third-party advisor or mediator could help. Try talking to an experienced founder who has been through multiple rounds of funding to get some different perspectives.
Negotiating options to alter the risk balance:
Consider a backstop position - specifying a minimum level of vested equity that a Leaver can retain may give some comfort to those who are concerned that they will leave empty-handed. Something in the range of 3-5% could still lead to a life-changing reward upon exit, without unduly hampering the cap table.
Change who redefines a ‘bad’ leaver into a ‘good’ one - is it a board majority or the investor director? Specifying that the remaining Founder(s) have input into the decision may help to reassure the whole Founding team that they won’t lose out if the investors ‘turn against them’.
Change the trigger to the point of notice - consider additional wording in the trigger clause around ‘having given notice to terminate their employment’ rather than just termination of employment - you may have a very long notice period in place for a Founder which may lead to more vesting than would be desirable.
Tighten definitions - Be careful with a very broad definition of ‘Service Provider’, for example, if a Founder remains as an advisor they may still be able to vest their equity.
Add a cliff - Consider an additional clause where the Founder loses all vested shares if the departure happens within one year of the vesting start date, or the date of adoption of the Articles. Note, this shouldn’t apply in the case of a sale event for the company.
Gotchas -
Check for alignment of definitions in all documents - not just in terms of the definitions of ‘Good’ and ‘Bad’, but also the notice periods and non-compete obligations in the Shareholders Agreement and any contracts or employment or Founder’s Service Agreements, and definitions of ‘Service Provider’. It’s better to get docs aligned now so you aren’t arguing about different wording further down the line.
Check for preemption - If any of the situations require the Leaver to sell their shares, check whether Founder shares are also subject to preemption and who the shares should be offered to first, so they end up where you want them to be.
Avoid ambiguity - terms like ‘with consent’ or ‘misconduct’ could be open to interpretation. It is worth clarifying these in the documentation.
Tax - Founders should also get advice on tax implications - there may be capital gains or income tax incurred upon any disposal of your shares.
Reality checkpoint: Reaching an agreement is going to take flexibility and a willingness to compromise, and this is a good opportunity to build this muscle which you are going to need (a lot). You might feel that your investor is not giving as much ground as you and unfortunately this may be the reality - they are starting from a different place than you. They’ve probably had this conversation a lot of times before, and have seen how badly it can end if they give too much ground at the start. But, this is another moment to take stock. If you can’t reach an agreement with your investor and don’t like their handling of this dispute, it might be a signal that this isn’t the right partner for you.
Keep it in perspective - arguing over the Leaver Provisions at the start of your relationship is not a great signal to your prospective investor. After all, they are only relevant if you think you may leave the business in the next four years. Given that it is likely that the vesting period will get reset wholly or partially at the next round of investment, think about whether this is really worth taking a stand over. You can’t legislate for every outcome in your legal docs. There is going to need to be a basis of trust between you and your investor that you both have the interests of the company at heart, and you will both make the right decisions down the road. If this isn’t there at the start, that isn’t the best foundation for a happy relationship between you both.
From the BVCA model documents: Articles
Definitions:
"Bad Leaver" means a person who:
(a) ceases to be [(or gives or is given notice to terminate their employment or consultancy as)] a Service Provider as a consequence of that person's:
(i) dismissal or termination as a Service Provider for gross misconduct, fraud, dishonesty or being convicted of any criminal offence (other than a road traffic offence which is not punishable by a custodial sentence) [or any grounds which entitle the Company to summarily dismiss or immediately terminate the Service Provider's employment, office, consultancy or engagement as a Service Provider], or as a consequence of that person's resignation in such circumstances; or
(ii) [resignation as a Service Provider [at any time during the Relevant Period], except in circumstances which constitute a constructive dismissal;] or
(b) after ceasing to be a Service Provider, commits a material breach of any non-compete obligations owed to the Company under the Shareholders' Agreement or under such person's terms of engagement or employment as a Service Provider or otherwise, even if such Service Provider did not cease to be a Service Provider by reason of being a Bad Leaver on their Effective Termination Date;
"Good Leaver" means a person who ceases to be a Service Provider and who is not a Bad Leaver and shall include when the Board [(including Investor Director Consent)] determines that a person is not a Bad Leaver;
"Leaver's Percentage" means, in relation to and for the purposes of determining the number of Service Provider Shares that are required (pursuant to Article Error! Reference source not found.) to be converted into Deferred Shares as a result of a Good Leaver ceasing to be a Service Provider, the percentage (rounded to the nearest two decimal places) calculated as follows:
Leaver's Percentage = 100 – ((1/[48] x 100) x NM),
where NM = the number of full calendar months elapsed from the Commencement Date to the Effective Termination Date, such that the Leaver's Percentage shall be zero on the first day of the [49th] calendar month after the Commencement Date and thereafter, and provided that if different Commencement Dates apply for different Service Provider Shares with respect to the same Service Provider, then the Leaver's Percentage shall be applied, and the number of Unvested Shares calculated separately, with respect to each group of Service Provider Shares having the same Commencement Date;
Article 19: Departing [Founder][Service Provider]
Deferred Shares
1.1 [Unless and to the extent that the Board [and the Investor Majority] determine that this Article 1.1 shall not apply] [[I]f at any time during the Relevant Period] [[I]f] a [Founder][Service Provider] ceases to be [(or gives or is given notice to terminate their employment or consultancy as)] a Service Provider (such person being a "Leaver"), the following proportion of the Leaver's Service Provider Shares shall automatically convert into Deferred Shares (on the basis of one Deferred Share for each Service Provider Share held) on the Effective Termination Date (or, if later, any other date on which the Board [with Investor Director Consent] determines that this Article 1.1 shall apply) and, in the event of any fraction, the number of Service Provider Shares so converted shall be rounded down to the nearest whole share:
(a) if the Leaver is a Good Leaver, the Leaver's Percentage of such Service Provider Shares; and
(b) if the Leaver is a Bad Leaver, all of such Service Provider Shares,
[save that if such [Founder][Service Provider] ceases to be a Service Provider within 12 months from the Commencement Date all of such Service Provider Shares shall so convert].
1.2 Upon such conversion into Deferred Shares:
(a) the Company shall record in the register of members of the Company each holder of Service Provider Shares so converted as the holder of the appropriate number of Deferred Shares; and
(b) the Leaver (and their Permitted Transferee(s)) shall deliver to the Company at its registered office the shares certificate(s) (to the extent not already in the possession of the Company) (or an indemnity for any lost certificate in a form acceptable to the Board) for the Service Provider Shares so converted; and
(c) subject to such delivery, there shall be issued to the Shareholder (subject to Article Error! Reference source not found.) new share certificate(s) for the number of Deferred Shares resulting from the relevant conversion and any remaining Service Provider Shares, held by such Shareholder.
If any Shareholder fails to so deliver to the Company any such share certificate (or such an indemnity for any lost certificate), the chairperson of the Company or, failing them, one of the Directors, or some other person nominated by a resolution of the Board, may as agent for and on behalf of, and in the name of, such Shareholder execute and deliver to the Company such an indemnity for any lost or absent certificate in a form acceptable to the Board.
Suspension of voting rights
1.3 All voting rights attached to Service Provider Shares held by a Leaver (and, if and to the extent determined by the Board, Service Provider Shares held by any Permitted Transferee of that Leaver) (a "Restricted Member") shall be suspended, [unless the Board [(acting with Investor [Majority/Director] Consent)] notify them otherwise,] as from the Effective Termination Date.
1.4 Any Service Provider Shares whose voting rights are suspended pursuant to Article 1.3 ("Restricted Shares") shall [not[1]] confer on the holders of Restricted Shares the right to receive a notice of and attend all general meetings (and receive copies of proposed written resolutions) of the Company [but/and] shall have no right to vote either in person or by proxy or to vote on any proposed written resolution. Voting rights suspended pursuant to Article 1.3 shall be automatically restored immediately prior to an IPO. If a Restricted Member transfers any Restricted Shares in accordance with these Articles (other than a transfer to any of their Permitted Transferees) all voting rights attached to the Restricted Shares so transferred shall (with the consent of the Board [with Investor Director Consent], not to be unreasonably withheld) upon completion of the transfer (as evidenced by the transferee's name being entered in the Company's register of members) automatically be restored.