Shareholder’s agreement: Employee equity

In the second part of our series on “Introduction to shareholder’s agreement”, we present to you the clause on Employee equity. 

Employee equity is a tax-efficient remuneration option for employees. The employees are taxed on the difference between the market value of the shares they acquire and amount paid for those shares at the time of the acquisition.  And the value of the shares is likely to be low at the outset of a venture. The sale proceeds of the shares are subject to capital gains tax rather than income tax in most cases.

Besides the tax benefits, offering equity to employees aligns their interests with those of shareholders. So it works towards increasing employee engagement and commitment while increasing employee welfare.

However, these benefits are not without any risks.

These risks could mean a key employee leaving the start up before the prescribed exit and refusing the buyback offer. Or there may not be a unanimous consent amongst the equity-holders to sell their shares back to the start up. There could also be discord on use of profits – some insisting on dividends while others on ploughing back in the business. These shares could land in the hands outside of the startup, such as spouse, heir, benefactor, creditors, etc.

Employee equity provisions in a shareholder agreement come handy in mitigating these risks. The key elements of the employee equity provisions are elucidated below

Drag along and tag along

“Drag along and tag along provisions” ensure across the board consent during sale of company, without being unfair

Given that buyers are often looking for complete control of a company, a drag-along provision is important during the acquisition of a company. It helps to eliminate minority owners and sell 100% of a company’s securities to a potential buyer to the sale of many companies.

The right enables a majority shareholder to ‘drag’ a minority shareholder to join in the sale of a company but not without offering the same price, terms and conditions as any other seller.

Since this type of provision brings homogeneity in the sale terms and conditions across the shareholding pattern, small equity holders can realize favourable sales terms that may be otherwise unattainable.

This provision prevents a minority shareholder to block the sale approved by the majority shareholder or a collective majority of existing shareholders.

Tag-along rights allow a minority shareholder to join the sale transaction that a majority shareholders is negotiating for its stake. A minority shareholders can, thus capitalize on a deal that a larger shareholder, often a financial institution, is able to put together. Institutional shareholders, such as venture capital firms, have considerable ability to source buyers for private equity shares and negotiate payment terms.

Since tag-alongs effectively oblige the majority shareholder to include the minority holder in the negotiations, it provides the latter greater liquidity.

Good leaver/bad leaver

Good leaver/bad leaver clauses set out terms of transfer of all or some of the shares of a shareholder based on the reason for departure. Good leaver/bad leaver clauses tie the end of employment with the end of share ownership. Good leaver clauses incentivises crucial founders to continue working until milestones are reached, while bad leaver clauses act as a deterrent to leaving early or breaching another contract (such as a director’s service agreement).

With this clause, the shareholder agreement defines the qualifications of good / bad leave. So a good leaver action will entail death; mental or physical incapacity that disallows working; redundancy; departure following change in employments terms of the founder; achievement of a particular event. The bad leaver action will entail fraud; termination for misconduct; exceeding limits of authority; disqualification as a director; breach of the shareholders’ agreement; failure to achieve certain targets before voluntarily leaving employment

Generally, good leavers are paid for their shares at fair market value, and bad leavers will have their shares bought at a discounted valuation. The price will be calculated as at the date of termination of employment.

Payment can also be delayed to a reasonable time to allow the start-up to raise money for the share purchases, and provide an incentive for the terms not to be triggered.

Employee equity could be an effective method for a start-up to acquire and retain talent – incentivise performance and tenacity. When a startup offers its equity at the outset, it attracts employees which it can’t afford to pay straight up using cash. With these provisions, the founder can also protect the start up from any pitfalls.