Good Leaver

What is a good leaver?

Good leaver (literally “good departing person”) is a founder, shareholder or employee who leaves for a reason that the contract does not hold against them. Contracts call the trigger a good leaver event; typical examples are permanent illness or termination by the company without good cause. The more favourable consequences of the leaver provision apply to them, that is, the clause that determines what happens to the stake on departure. The stake already earned is retained or paid out at its full value. Only the portion not yet earned reverts at a low price.

The classification is governed by the leaver clauses, often summarised as the good leaver/bad leaver clause. For founders, they are in the shareholders' agreement, the contract between the shareholders, and additionally in the articles of association; for employees, in the terms of the participation programme (ESOP). They work together with vesting, which determines what portion of the stake has been earned at the time of departure. The leaver rules are usually negotiated already in the term sheet of a funding round. The counterpart is the bad leaver.

Typical good leaver cases

Which cases are covered follows solely from the contract. In German participation agreements, the following circumstances are widespread:

• Death and permanent incapacity for work: departure because of death, reduced earning capacity or an illness that permanently precludes the activity.
• Termination by the company without good cause: ordinary termination of the employment contract or, for managing directors, removal from office, without any conduct of the person giving rise to it.
• Resignation for good cause: the person gives notice because the company has itself breached material obligations.
• Reaching an age limit or an agreed retirement.
• Time-dependent classification: A resignation without good cause counts as a good leaver case only after a minimum period, for example after two or three years.

A peculiarity must be noted for managing directors. Under Section 38 (1) of the German Limited Liability Companies Act (GmbHG), the shareholders can in principle remove a managing director at any time, and the office and the employment contract are legally separate. If the clause refers only to termination of the employment contract, it remains unclear how a removal from office while the contract continues is to be classified. Careful clauses name both events.

Consequences for the good leaver: shares, price and valuation

Earned and unearned shares

For a good leaver, the earned portion of the company shares generally stays with the departing person. Many contracts additionally give the fellow shareholders, the investors or the company a purchase right at fair market value, that is, at the price an independent buyer would pay. This keeps former founders from continuing to take part in decisions with voting rights. The unearned portion must be surrendered, usually at the nominal amount (nominal value), the amount per share fixed in the articles of association, often EUR 1. Some contracts apply the lower of nominal amount and fair market value. The shares are thus not forfeited; they pass in return for consideration, either by assignment or by compulsory redemption (Einziehung).

For virtual programmes, the same applies correspondingly: earned virtual shares remain in place until the exit and are then paid out, unearned ones lapse. Some plans additionally grant good leavers a pro rata continuation of vesting for several months.

Determining the fair market value

The fair market value (fair market value) of a company share in an unlisted company is not fixed. Contracts therefore lay down a procedure. Often an independent auditor (Wirtschaftsprüfer) values as an expert arbitrator, partly under IDW S 1, the valuation standard of the German auditors' institute (IDW), partly by reference to the price of the last funding round. That price applies to shares with preferential rights and cannot simply be transferred to ordinary shares, because the investors' liquidation preferences reduce the value of the other shares. It must also be settled who bears the costs of the valuation and whether the settlement may be paid in instalments.

Good leaver clauses under German law

A clause that allows a shareholder to be forced out of the company without objective reason (Hinauskündigungsklausel) is in principle regarded by the German Federal Court of Justice (Bundesgerichtshof) as contrary to public policy and therefore void under Section 138 of the German Civil Code (BGB). It has, however, recognised arrangements in which the stake is recognisably tied to an activity as managing director or employee and is to be returned when that activity ends (manager and employee models). Whether these principles can be transferred to founders with a substantial stake depends on the individual case. The closer the consideration is to fair market value, the lower the risk that a clause will not stand up in court. For the good leaver, who keeps the earned portion or is compensated at full value, this risk is therefore low.

Under company law, capital maintenance must be observed. If the company itself acquires the shares or redeems them, that is, cancels them by shareholder resolution, it may pay the price only out of free assets. These are assets that exist over and above the share capital (Section 33 (2) and Section 34 (3) GmbHG). Without the consent of the person concerned, a redemption is possible only on the basis of a provision in the articles of association that already existed before the share was acquired.

There is also a tax consequence for the good leaver. If the unearned portion is surrendered at the nominal amount although it is worth considerably more, the difference can be treated as a gift under Section 7 (7) of the German Inheritance and Gift Tax Act (ErbStG). Gift tax can then arise for the acquirers or the remaining shareholders. Whether and in what amount this occurs depends on the tax value of the shares and belongs in the review by the tax adviser.

Negotiating the good leaver provision

The negotiation is less about the clear cases than about the grey zone in between. Founders prefer a catch-all rule under which anyone who is not expressly a bad leaver counts as a good leaver. Investors prefer an exhaustive list of good leaver cases. The biggest point of dispute is resignation without good cause, which many contracts treat as a bad leaver case in the first years and as a good leaver case afterwards. Many contracts also know an intermediate category for cases such as amicable separation, with consideration between the two levels.

The classification also matters after a company sale. With a double trigger (accelerated vesting), the question whether there is a termination without good cause decides at the same time whether unearned shares are accelerated. The definitions in the leaver clause and the acceleration rule should therefore match.

Worked example: calculating a good leaver's settlement

A co-founder holds 15,000 of the 60,000 company shares of a GmbH (German limited liability company) with share capital of EUR 60,000. Reverse vesting over 48 months with a twelve-month cliff is agreed. After 20 months she leaves because of permanent illness and counts as a good leaver. For earned shares, there is a purchase right at fair market value; the expert arbitrator determines EUR 90 per share. Unearned shares are to be surrendered at the nominal amount of EUR 1. The company reports book equity of EUR 450,000.

• Earned: 15,000 × 20/48 = 6,250 shares
• Unearned: 15,000 minus 6,250 = 8,750 shares, consideration 8,750 × EUR 1 = EUR 8,750
• Exercise of the purchase right for the earned shares: 6,250 × EUR 90 = EUR 562,500
• Total consideration: EUR 562,500 plus EUR 8,750 = EUR 571,250
• If the company itself is to acquire: book equity EUR 450,000 minus share capital EUR 60,000 = EUR 390,000 free assets
• Shortfall: EUR 571,250 minus EUR 390,000 = EUR 181,250

The company could pay for the acquisition out of free assets only in part. Practicable here is acquisition by fellow shareholders or investors, or a combination with instalment payments, to the extent the contract permits. The example shows why purchase rights should provide for several entitled parties in a fixed order. At the same time, the consideration for the 8,750 unearned shares is below fair market value by 8,750 × EUR 89 = EUR 778,750. If the tax value corresponds to fair market value, Section 7 (7) ErbStG applies to this amount.

Distinctions: good leaver, bad leaver, vesting and accelerated vesting

• Bad leaver: the counterpart. The departure is attributed to the person, and the consideration lies far below fair market value.
• Vesting: determines how much of the stake has been earned at the time of departure. The leaver classification determines what is paid for it.
• Accelerated vesting: makes unearned shares vest early on a sale. The good leaver rule, by contrast, applies on every departure, regardless of a sale.

Common mistakes

• List without a catch-all rule. Cases such as amicable separation or the expiry of a fixed-term contract fit no category and lead to disputes.
• Fair market value without a procedure. If expert, valuation method and cost allocation are missing, the price is negotiated only after the departure, in a situation without pressure to agree.
• Removal from office not covered. If the clause names only termination of the employment contract, removal as managing director without termination remains unregulated.
• Capital maintenance overlooked. If only the company is entitled to acquire, the buy-back fails as soon as the free assets are insufficient.
• Contradictory definitions. If articles of association, shareholders' agreement, employment contract and acceleration rule deviate from each other, it is open which classification applies.

Frequently asked questions

What is the difference between a good leaver and a bad leaver?

The reason for the departure and the price. The good leaver leaves for a reason that the contract does not hold against them and keeps their earned shares or receives fair market value for them. The bad leaver is responsible for the departure themselves and must surrender shares, often including earned ones, far below value.

Does a good leaver keep their earned shares?

As a rule, yes. Often, however, the fellow shareholders or investors have a purchase right that transfers the earned shares against payment of fair market value. Economically, the value of the earned stake is then preserved.

What does a good leaver receive for unearned shares?

Usually only the nominal amount or the lower of nominal amount and fair market value. The unearned portion is meant to become available for new key people, which is why it is not paid at fair market value even for a good leaver.

Is resignation a good leaver case?

Only if the contract provides for it. A common arrangement is that a resignation without good cause counts as a good leaver case only after a minimum period, or an intermediate category with a discount on fair market value.

What happens to the shares on the death of a founder?

The shares first pass to the heirs, because company shares are heritable under Section 15 (1) GmbHG. Articles of association and shareholders' agreement often provide that the company can redeem them or demand their assignment; as a good leaver case, the heirs then receive the agreed value for the earned portion.

What does a good leaver clause contain?

The cases that count as good leaver and their consequences for earned and unearned shares. A complete clause also regulates the procedure for determining fair market value, the entitled purchasers in a fixed order and the manner of payment. It generally ends with the initial public offering (IPO) or the sale of all shares. The wording is drafted by the law firm to fit articles of association and shareholders' agreement.

The Roemer Capital view

Before founders sign a term sheet, Roemer Capital calculates for each of them what the proposed leaver categories mean in euros. The overview shows the values after twelve, 24 and 36 months, in each case as a good leaver, in an intermediate category and as a bad leaver. It makes visible which definitions count economically and directs the negotiation to the grey zone instead of the clear cases.

In sale processes, Roemer Capital compiles early which leaver cases there have been in the past and how they were settled, because open claims of former founders concern every acquirer. The drafting of the clauses lies with the company's law firm.