The Bad Leaver mechanism (as well as the Good Leaver mechanism) forms an important part of the agreement between startup’s shareholders. The basic idea is that it should preemptively protect the value of the company from undesirable behaviour by its shareholders.
The Bad Leaver mechanism can be encountered for the first time in the life of a startup when entering into a Shareholders’ Agreement (SHA) (without the involvement of an investor) or when negotiating a Term Sheet with an investor. The Bad Leaver is triggered when a shareholder:
- leaves the company before a certain agreed period of time; or
- seriously breaches their obligations; or
- breaches the terms of the SHA.
The most common result is that the shareholder loses their share in the company for less than its market value.
The basis for understanding the Bad Leaver mechanism
A Bad Leaver mechanism protects the company, and therefore the investor’s investment, by discouraging a shareholder who is important to the company either
- from leaving the company before the agreed date; or
- from committing any misconduct or breach that could harm the company (which usually occurs through a breach of a contractual obligation).
If a Bad Leaver is triggered against a shareholder, such shareholder incurs obligations that ultimately result in the loss of their share in the company.
A shareholder leaving in breach is obliged to transfer the ownership of their share in the company to the other shareholders or company (this is the biggest difference from a shareholder leaving as a Good Leaver, where the shareholder is usually allowed to keep some part of their share in the company), for a consideration lower than the market value of that share. The rules of Bad Leaver should be clear before such a mechanism is activated and should be agreed to by all the parties, which is why this mechanism is regulated in the SHA.
The most common cases of leaving as a Bad Leaver
There are no strict rules in determining the situations that trigger a Bad Leaver departure. The specific wording depends on the agreement of the parties. A Bad Leaver is often set quite broadly: for example, that it covers any departure of a shareholder from the company that does not fall under a Good Leaver departure, or that a shareholder becomes a Bad Leaver if they repeatedly breach the duties of the obligations set out in the SHA.
Outside of such a general setup, the most common situations that trigger Bad Leaver in particular are:
- Voluntary departure of a shareholder before the expiration of the “lock-up period”. The “lock-up” period is the period of time during which the shareholder has committed to be active in the company; this is especially in the early stages of a company, usually lasting three to four years after the signing of the SHA;
- A material breach of the shareholder’s employment/supply agreement(s) with the company;
- Breach of the non-competition clause;
- A serious and wilful breach of the shareholder’s obligations;
- Fraud and embezzlement;
- Final conviction of the shareholder for any serious criminal offence;
- The insolvency of the shareholder; or
- The entry of the shareholder into liquidation.
The departure of a Bad Leaver
When a Bad Leaver is triggered, a departing shareholder in breach is required to transfer their share in the company to all other shareholders on a pro rata basis. That is according to the relative proportion of their share in the company, for a consideration equal to its nominal value (which means at a discount to the fair market value of that share).
The Bad Leaver mechanism should therefore cover the determination of who can buy the share and address the situation where no other shareholder wants to buy the share.
By the fact that the Bad Leaver is not regulated by law, its setting depends entirely on the agreement of the parties. Given the consequences of activating a Bad Leaver mechanism for a shareholder, due care should be taken to ensure that all shareholders have a clear idea of what will happen to their share.
Author: Lenka Letková
Editor: Jarmila Koubeková