Breaking up is the hardest part – thoughts on leaver provisions for venture backed managers
One of the things that we always find challenging during deal legals is agreeing leaver terms with managers and founders. In essence these are the rules that determine what happens to manager and founder shares if a manager leaves the company they work for or founded.
Many founders are not even aware at the outset that almost any institutional investor will require some form of leaver provisions to be in place. This blog aims to set out why we think these terms are important, why we think founders and managers should also think they are important and it describes our “ideal” set of leaver provisions.
Why do we need leaver provisions?
The fundamental driver behind these principles is that in the absence of leaver and vesting provisions equity has a perpetual and irrevocable share of value. This causes an issue if equity is used as an incentive to reward non-financial personal contribution. In the event that a manager or founder leaves and keeps any equity they have they share in both the value created to date, but also future value, which they might not contribute to in any way.
This is an issue in that it essentially taxes the people who contribute to ongoing growth by diluting their share of any future value creation. This situation is exacerbated when a company needs to provide an equity incentive to a new recruit coming in to replace a departing manager or founder which would dilute all existing shareholders.
As institutional investors we think that it is important to put in place a fair set of leaver provisions so that the investors who are backing the team as a whole don’t suffer if one of that team is no longer contributing to the business because we have to issue additional dilutive equity to new joiners.
As well as being important for us we think that well drafted leaver terms are something that founders and managers should also welcome. Very often managers and founders are resistant to leaver provisions, thinking about the risk of value loss if they become a leaver. This is sensible, but it is equally important to reflect on the consequences of being a “stayer” and essentially picking up the bill in a situation when colleagues leave.
We see more stress amongst staying founders and managers realising how much value they have given and will continue to give to leavers who cease to contribute to value creation than the other way round. Well drafted leaver provisions protect staying management shareholders as well as institutional investors.
What are the goals of leaver provisions?
We think that there are some fairly obvious and fair goals of leaver/vesting provisions:
- To acknowledge historic contribution to value creation of a leaver
- To minimise the dilutive effect on staying shareholder of incentivising a new joiner
- To minimise the immediate cash liability for the company or staying shareholders at the point of leaving
- To use a simple as possible framework to manage leaver situations
- To recognise that there is sometimes a difference in appropriate treatment between founders and later employed managers
Practical reflections on valuation
- At the point of an investment round there is a marker of notional value that allows any incumbent founder or manager to calculate the value of their stake in the business. This valuation typically includes both a value ascribed to the already established business and a value ascribed to potential future growth as seen at the time of the round and so already provides a degree of “look forward” value.
- It should be noted that it is not uncommon for a liquidity discount to be applied if someone actually wanted to sell shares as part of a round reflecting the value of certainty over uncertainty.
- Between rounds there is value change, but in practical terms it is extremely difficult to establish with any rigour the level of value change.
How would we ideally achieve these goals?
We set out below our ideal set of leaver provisions to help you understand how we seek to implement these goals in practice. They may look complicated, but we think that they are the simplest way that we can effectively achieve the goals set out above. We don’t insist on these terms, very often other investors have a different approach and we sometimes need to compromise to agree a solution that works for everyone.
- Someone who is required to leave as a result of poor performance, poor behaviour or who chooses to leave unexpectedly in the context of the investment life cycle should forfeit all equity based compensation. These are “Bad Leavers”
- We think of “unexpected” based on the fact that when we invest we have a standard expectation that managers will remain in post for at least 3 years. If managers make clear other personal plans at the outset we will adjust both vesting time frames and the level of incentive to fairly reflect these plans.
- We recognise that sometimes personal circumstances change for a leaver making the unexpected test unfair. In these circumstances we will retain the ability to apply discretion to allow managers to benefit from some or all of the historic value creation by classing them as partially or wholly Good Leavers.
- Poor behaviour includes leaving to work with a direct competitor organisation within a year of leaving.
- Other leavers, classed as “Good Leavers” should be permitted to offer to sell their shares at the point of leaving to existing shareholders through a standard pre-emption process.
- In the event that shares are not sold a Good Leaver should retain rights to historically created value.
- In practice to enable this to happen in a way that meets the goals set out above this should be implemented by shares being purchased by the company [or an EBT type vehicle] for Loan Note consideration or swapped for Good Leaver Deferred Shares.
- The Loan Notes or Deferred Shares should be redeemed as a “Tag along” when the majority of investor shareholders exit.
- The redemption value of the Loan Notes/sale price of the Deferred Shares should be the lower of:
- The value per Ordinary Share of the surrendered equity at the round preceding leaving plus an annual interest accrual to the date of exit of 5%.
- If there are future “down rounds” the value per Ordinary Share of the lowest priced subsequent fundraising round plus an annual interest accrual to the date of exit of 5%.
- The value per Ordinary Share of the exit
- Reasonable protections will be put in place to ensure that share splits etc do not exploit this situation.
- Additional value protection will be offered by giving leaver LN and DS holders pre-emption rights to subscribe for new equity in subsequent investment rounds as if they were shareholders.
- Good Leavers will be allowed to offer their Deferred Shares to existing shareholders at any point.
- In the event a leaver is a Good Leaver at the point of leaving but starts working with a direct competitor (as an employee or otherwise) the LN/DS redemption value will fall to nil.
- Where, at the point of investment, Founders have equity holdings that reflect their founder status (i.e. are materially higher than would be expected for a “recruited” manager of similar capability) an appropriate proportion of their shareholding will be considered fully vested at the outset and not subject to leaver terms with the balance falling under the manager leaver provisions.
- The proportion classed as Founder Equity will be a judgement call at the time of the deal but should in no circumstances exceed 50%.