Startups are as much about people as they are products, and especially the founders. So when negotiating with investors, one of the key risks that they will pick up on is “what happens if one of the founders leaves?”. This is always going to be a crucial discussion point for any growing team when assessing the future plans of a startup.

Whether driven by personal reasons, professional conflicts, or new opportunities, a founder leaving the company can significantly impact its future prospects, especially if clear provisions are not in place to account for treatment of that founder’s shares when they become a leaver. In this blog, we will address critical points for founders to consider and provide a breakdown of the main different departure scenarios - good leavers, bad leavers, and voluntary leavers. We will explore these concepts and their impact on your startup's equity structure.

What Happens to Shares if a Founder Leaves?

Typically, in standard startup legal and investment documents, there is a mechanism known as reverse vesting. This is a safeguard to ensure that founders earn their shares over time, and if they leave early, the unvested shares revert to the company or the remaining founder(s). For a detailed explanation aso see: our article on reverse vesting for departing founders.

Different Types of Leavers

When a founder leaves, they will be categorised as a good leaver, bad leaver, or voluntary leaver. The treatment of their shares will depend on this classification. These definitions are outlined in the company’s articles of association and/or shareholders' agreement. Defining these categories precisely ahead of time is essential, and it’s advisable to seek professional legal advice before finalising these definitions to ensure all bases are covered.

In our experience, there is a very broad spectrum for how each of these leaver types can be defined. The broader the definition, the easier it is to fall into the relevant category when leaving.

Bad leaver

A very broad definition of a ‘bad leaver’ is generally harsher on a departing founder because it means they are more likely to be classed as one, and this can have serious consequences (see below). Whereas a narrow definition means it is much more difficult for a departing founder to be classed as a bad leaver.

Bad leavers usually lose everything, including vested shares, and often for no compensation. It is crucial to clearly define what constitutes a bad leaver in your documents to avoid ambiguity. A bad leaver typically includes individuals who are terminated for cause (i.e. fired), for example for gross misconduct, breach of fiduciary duties, or other significant violations of their service contract. The rationale is that these behaviours are detrimental to the company, justifying the forfeiture of shares. This acts as a disincentive for someone to do those things given the very serious consequences for their position in the company and their right to continue holding shares.

Key considerations for defining a bad leaver:

• Does this classification apply indefinitely or only during an agreed vesting period?

• Does it affect all shares or only some? Are some shares held unconditionally outside of the leavers regime?

• Are the shares returned for £0, or is the bad leaver entitled to receive any value?

• Does a bad leaver include someone who resigns?

• Does a bad leaver include someone who is is underperforming and required to leave, rather than simply having done something specifically wrong?

• Can someone become a bad leaver later if they breach their non-compete or non-solicitation restrictions after having left?

Good Leavers

Good leavers, on the other hand, are often allowed to keep their vested shares or may be required (or given the option) to sell their vested shares at market value, determined by accountants or CFOs typically. We usually see that a good leaver is anyone who is not a bad leaver, or if applicable, a voluntary leaver. In addition, it usually covers a founder who can no longer contribute to the company due to health issues, where it is reasonable to categorise them as a good leaver, allowing them to retain or sell their vested shares or sell them at a fair value. This reflects a more humane approach and acknowledges their contributions to the company.

Typical scenarios for good leavers include:

• Anyone who does not fall into one of the other leaver categories

• Health issues preventing them from continuing to work

• Retirement (though less common in startups)

• Death of the founder

• Voluntary resignation after the vesting period

Voluntary Leavers

Voluntary leavers are founders who resign by their own choice. The definitions of good or bad leavers can include a voluntary leaver, or alternatively a voluntary leaver can be its own defined category with its own consequences. For example, where a bad leaver might lose all of their shares, and a good leaver may be able to keep all of their vested shares, a voluntary leaver might be somewhere in between with an entitlement to keep 50% of their vested shares, The classification of a person leaving voluntarily depends on the company’s definitions and their circumstances. A key distinction here is whether the resignation occurs during or after the vesting period.

For instance, a founder who leaves voluntarily after the vesting period might be considered a good leaver and retain their vested shares. However, if they leave during the vesting period, they might be treated as a bad leaver, depending on the terms agreed upon in the shareholders' agreement.

Key Considerations

• Definitions are Essential: The definitions of good, bad, and voluntary leavers are critical. Incorrect or vague definitions can lead to disputes and complications. It’s important to define these upfront and even before the fundraising process.

• Share Retention Conditions: The classification of leavers determines whether shares are required to be returned (bad leaver) or can be retained (good leaver).

• Share Return Conditions: The classification of leavers determines whether shares are returned for £0 (bad leaver) or at fair market value (good leaver).

• Professional Advice: It’s wise to seek legal and financial advice when drafting these definitions to ensure they are clear and unambiguous. Our experience working with startups on these documents, and also working directly on founder departure situations means we are well placed to advise on the right positions for our clients based on their own plans and circumstances.

• Articles and Shareholders Agreement: These definitions should be included in the articles of association and/or shareholders' agreement and are typically linked to a reverse vesting schedule.

Additional Insights and Best Practices

• Consideration of Vesting Periods: Reverse vesting schedules should be carefully considered. A common approach is a four-year vesting period with a one-year cliff (although this is entirely variable depending on your businesses’ strategy and goals). This means that no shares are vested if a founder leaves within the first year, but after the first year, they begin to vest monthly or quarterly, backdated to the start of the cliff period.

• Inclusion of Vesting Acceleration Clauses: Founders will generally want to ensure that all of their equity vests on the occurrence of an exit, even if they have not fully vested..

• Drafting Clear Employment Contracts: Employment contracts should align with the terms in the articles of association and shareholders' agreement. Any discrepancies can lead to legal challenges and misunderstandings.

• Periodic Review of Agreements: Regularly reviewing and updating these agreements ensures they remain relevant and reflect the current dynamics of the company and its founders.

• Transparency and Communication: Clear communication with all founders about these terms helps to manage expectations and reduces the likelihood of disputes.

Understanding the nuances of leaver classifications and their impact on shareholding is crucial for founders, especially during fundraising. Clear and precise definitions, backed by professional advice (from Accelerate Law or your chosen legal advisors), can prevent future disputes and ensure fair treatment for departing founders. As always, the best approach is to proactively address these issues through well-drafted agreements and continuous review and adaptation to the evolving needs of the company and its stakeholders.

Accelerate Law provides flexible strategic and legal support to startups end-to-end through angel investment rounds and VC funding rounds, which includes supporting with SEIS and EIS matters, flexible funding for example through Advanced Subscription Agreements, and drafting and negotiating investment terms from term sheets through to completion. Accelerate Law also specialise in EMI Schemes for startups. Contact us here to find out more.