The founders and exec team are a critical component of an early-stage company’s business value. In a previous article, we provided detailed guidance on the comparison of U.S. and UK market practices in relation to equity awards. In this article, we focus on contractual share forfeiture provisions, which investors in both the U.S. and UK technology ecosystems seek to use to dissuade founders and employees from leaving the company.
These share forfeiture provisions take the form of vesting and leaver provisions, which will determine what happens to founders’ and employees’ equity when they leave the company. While both the U.S. and the UK markets use similar tools, the market-standard approach varies significantly between the two.
In this article, we will first explain the common tools used in both the U.S. and the UK. We will then compare the different market approaches in the U.S. and the UK. We will also consider how the U.S. experience can inform negotiations for UK-based companies and founders. While this article focuses on UK companies, a number of the concepts described here are also similarly applicable to European companies.
What Is Vesting?
Vesting is the process by which an individual gradually earns (or re-earns) their shares. The most common formulation is time-based vesting that merely tolls as long as a founder/employee remains in the service of the company. By incentivizing employees to remain with the company for extended periods of time, the company is more stable and attractive to investors who want assurances that the founders and employees of the company will continue to grow the business.
Mechanically, vesting operates in two common ways. Forward vesting allows an individual to obtain their shares (or rights to acquire shares) gradually in installments and become fully vested over time. By contrast, reverse vesting restricts existing shares in the hands of the founder/employee with a requirement that company can reclaim any unvested shares in the case that certain conditions are not met before such individual’s departure from the company.
The most common vesting period for time-based vesting is over four-years with a one-year cliff (i.e., 25 percent of the shares become fully vested after one year) and monthly or quarterly vesting thereafter, such that the award is fully vested at the end of the four-year period subject at each time to continued service. The cliff is a common mechanism to avoid leaving valuable shares in the hands of short-term employees.
Time-based vesting is the predominant market standard for private companies and for most rank-and-file employees. However, performance-based or milestone awards are occasionally provided to senior-level employees, more typically in public companies.
Performance-based vesting, as the name suggests, sets out certain milestones that determine the relevant vesting schedule for an individual’s shares. For example, an individual may receive 50 percent of their shares if certain revenue goals are met. This type of vesting is used to motivate the most senior level employees or executives towards achieving certain pre-agreed targets. As a general matter, milestones can be challenging to apply because they require some objective standard or measure of performance that may not be quickly evaluated. For example, a measurement based on revenue may not be ascertainable until after an employee is terminated since results of operations may not be immediately available or audited for weeks. This can make for difficult situations when a company parts ways with an employee. As a result, these are more commonly used in more tailored situations.
Any shares that do not vest in each case typically revert back to the issuing company for continued use under the equity plan/scheme.
What Are Acceleration Provisions?
In some situations, founders will negotiate for situations where their vesting accelerates faster than the original schedule. These typically come in two forms: single-trigger and double-trigger.
Single-trigger is less commonly used as it only requires a single event. Typically, either sale of the company or alternatively a termination of employment either without “cause” or resignation for “good reason.” This format is most commonly used for employees that are expected to be redundant in an acquisition (e.g., legal and financial personnel that are duplicative sometimes in a business combination).
Double-trigger is often used for founders as a compromise to extending vesting periods and to align with efforts to obtain a sale event. This format requires both sale of the company AND a proximate (often 60 days prior or 12 months after) termination of employment either without “cause” or resignation for “good reason.”
What Are Leaver Provisions?
More typical to non-U.S. deals, leaver provisions determine the status of an employee at termination. Most commonly, these determinations allow a company to reclaim some or all of the shares held by the founder/employee against the will of that employee. Unlike vesting, which often is something of a “carrot” to employees, leaver provisions serve as a “stick” to keep employees from leaving on terms that the company does not like.
In the UK, leaver provisions tend to be highly negotiated. Although certain tools such as the BVCA Model Documents have attempted to standardize this, they remain an area of significant discussion on deals.
Departing the company as a “Good Leaver” generally results in only the holder’s unvested shares being forfeited, while departing as a “Bad Leaver” generally results in a portion of the holder’s vested and unvested shares being forfeited. It is not uncommon for 100 percent of shares to be subject to forfeit in those instances. Some leaver provisions also introduce the concept of an “Intermediate Leaver,” in between the extremes of the “Good Leaver” and “Bad Leaver” scenarios. To the extent the shares are repurchased or offered up for purchase to existing investors, the price at which the vested shares will be repurchased tends to be negotiated with “Bad Leaver” shares typically being repurchased at nominal value and other forms often at an agreed “market” value.
What circumstances constitute a “Good Leaver” versus a “Bad Leaver” (versus “Intermediate Leaver”) are typically heavily negotiated. The specifics of various departures can differ, often leaving it to the discretion of the company’s board of directors to determine whether someone is a “Good Leaver” or a “Bad Leaver.” Generally, death, disabilities, retirement, and redundancy will all count as Good Leaver, whereas dismissal for “cause” (e.g., fraud, gross misconduct, or criminal conduct) or resignation where cause exists will count as a Bad Leaver. The treatment of voluntary resignation without “good reason” is sometimes treated as a Bad Leaver scenario (or, in some cases, an “Intermediate Leaver” scenario), although that is increasingly less common.
In addition, in the UK, retained leaver shares tend to lose all voting rights. This differs from the U.S. where founders tend to lose contractual rights such as for specific board seats or in a drag-along vote upon departure but otherwise retain share voting rights. This is likely due to the fact that English companies have certain situations that require a resolution of a supermajority of 75 percent of outstanding shares to take certain actions, such as amend the articles, making it much harder for a company to continue with outstanding shares held by departed founders. By contrast, U.S. companies usually do not have a statutory requirement for such a large vote.
U.S. Versus UK Approaches
U.S. NVCA-style deals generally include a time-based vesting schedule on founder shares. Founders often can negotiate for double-trigger acceleration as well. However, leaver provisions are otherwise highly uncommon in NVCA-style deals.
UK BVCA-style deals similarly include time-based vesting schedules with the market standard being the same as the U.S. as to the time periods. However, they also tend to include heavily negotiated leaver provisions that dictate different levels of share retention based on the manner in which a holder leaves the company. These tend to be more common when the investor is a non-U.S. investor, as many U.S. investors do not seek to impose leaver provisions in UK companies.
The difference in approaches in the U.S. and UK are rooted in market trends and the standards of employment contracts in each jurisdiction. The U.S. style of at-will employment parallels the time-based vesting with no leaver provisions. U.S. employment contracts rarely set out enumerated differences in circumstances of an employee’s departure and favor all employment contracts to be at-will arrangements. Time-based vesting leads to crisper discussions surrounding vesting when an individual leaves a company regardless of the surrounding circumstances. Further, employees in the U.S. tend to expect that they will keep whatever shares have vested at the time of their departure regardless of the circumstances of their departure.
UK leaver provisions tend to mirror concepts found in UK employment arrangements where the circumstances of an employee’s departure are relevant to determining their rights, and employees more commonly have notice periods.
While the U.S. approach is much easier to negotiate and implement, the drawback of the U.S. approach is it can be very difficult to remove departed founders or employees from the company’s cap table after their shares have vested. If a founder holds a significant stake in the company, considering their retained voting rights, this can also create obstacles for the company in the future if such founder were a Bad Leaver and continued to hold a material position.
However, while the leaver regime in UK companies provides a framework to remove leavers from the cap table and to prevent them from becoming an obstacle to the company, negotiating the parameters of an appropriate vesting schedule and leaver provisions can result in significant friction between founders and investors and hefty legal costs. Furthermore, determining when a leaver is a “Bad Leaver” can be a fact-intensive exercise that is rarely straightforward, which presents the prospect of potential legal claims by the departing employee against the company. While investors often want more flexibility for the board to make these determinations, founders will often seek determination by a court or tribunal for the bad leaver provisions to be binding. Practically, leaving this determination solely to the company is not likely to be terribly effective. If a board determines a founder is a bad leaver without a release and agreement with that founder, the founder may be a potential litigation risk. While the company may think this allows it to simply move on, subsequent investors or buyers are not going to be satisfied with votes premised on a disputed determination that the founder was a bad leaver. That means, realistically, that the leaver provision may not serve the purpose for which it was intended since the parties will not be able to rely on the outcome of votes and the revised capitalization table until the company and founder agree on the founder’s leaver status.
Considering the U.S. Approach in UK Transactions
Considering the pros and cons of both the U.S. and the UK approaches, as with most matters, there is not a one-size-fits-all approach. The right approach is the one that optimizes between reasonably calibrating between the investors’ and founders’ risk, while minimizing unnecessary friction and negotiation.
Most UK and European-based investors expect their investment in the company to be accompanied by vesting and leaver provisions. If leaver provisions are non-negotiable, a UK founder would be better placed negotiating the parameters of such leaver regime as compared to trying to push the U.S. framework.
Where we see greater latitude for negotiations is in the scenario where U.S. VC investors lead a fundraise. In this scenario, there can be a greater willingness from the company’s investor-base to soften or altogether remove leaver provisions, if the lead U.S. VC is supportive. If this approach is taken, UK companies should be mindful of ensuring that any contractual founder veto rights that may be negotiated fall-away if a founder ceases to be employed with the company.
For more information on contractual share forfeit provisions, please contact Wilson Sonsini attorneys Jose Campos or Bradley Doline.
