Good Leaver in the context of a startup’s pre-seed investment round

The Good Leaver mechanism forms an important part of the agreement between startup’s shareholders. The basic idea is that it should be a well-balanced instrument and it should protect the company, the founders, and last but not least, the investment of the investors themselves. 

The Good 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. When joining a company or starting a business ensuring a Good Leaver mechanism is in place may not be a top priority, but this mechanism is very important when a shareholder leaves the company (either voluntarily after possible agreement with other shareholders, without such agreement, or based on circumstances beyond their control). At this point it will matter whether and how Good Leaver is set up, as the consequences of departure are very different depending on if Good Leaver or Bad Leaver mechanisms. 

The basis for understanding the Good Leaver mechanism

The Good Leaver mechanism determines under what conditions a shareholder (usually the founder) may retain the vested part of their share in the company (depending on the legal form of the company) upon leaving the company. Furthermore, it also defines the circumstances of the mandatory transfer (loss) of the unvested part of their share in the company.

If events occur that trigger a Good Leaver situation, such a shareholder will leave the company, but at the same time will be rewarded for remaining in the company for a certain period of time before leaving and participating in the achievement of its objectives.

Practically, the sharesholder will commit in a SHA to be active in the company for a certain period of time, often referred to as a “lock-up period” and usually lasting three to four years. During the lock-up period, such a shareholder reverse-vests their shares in the company, and in the event that triggers the Good Leaver or Bad Leaver mechanism, and some or all of the shareholder’s share is transferred.

If a shareholder becomes a Good Leaver, they lose their unvested portion of the shares, but can retain the vested portion of the shares. By default, this is the most important difference from the Bad Leaver mechanism, where the shareholder loses the right to the entire shares, regardless of whether it is vested. The unvested portion of the shares must be sold by the Good Leaver, in most cases, either at fair value (i.e., “market value”) at a discount or at nominal value. The unvested portion of such shares is mostly used as a tool to incentivize (current or new) team members to replace the departing shareholder, or is distributed pro rata to the remaining shareholders of the company. 

The main reason for using the Good Leaver mechanism is that it can be seen as an incentive for the founders (or other key persons with a stake in the company) to be active in the company in its early days, when their personal involvement in the development of the business is most needed. This makes a lot of sense for the founders among themselves as well as for the investor, who indirectly protect their investment.

The most common cases of the Good Leaver application

There are no strict rules in determining the situations that trigger a Good Leaver exit. The specific wording depends on the agreement of the parties. Among the most common situations that trigger a Good Leaver situation is when a shareholder’s relationship with a company is terminated. This can be a termination of a contract, whether an employment contract or a contractual agreement between such shareholder and the company. In particular, the following reasons may apply: 

  • Retirement
  • Permanent incapacity for work due to illness. It is necessary to think about the definition of incapacity for work, i.e. how long it should last, who will certify it (e.g. a doctor in the territory of the country where the company is based).

In addition to these situations, it is also possible to encounter reasons including: 

  • Investor’s consent. This would be any departure of a shareholder from the company that the Investor decides would be a situation triggering the Good Leaver even though it would not be defined in the shareholders’ agreement.
  • Voluntary resignation. This will depend on the negotiation but occurs mainly in conjunction with a resignation occurring after some agreed time.
  • Dismissal by the company if the shareholder has failed to meet certain KPIs. Particularly where the failure to achieve the KPIs was not solely within the control of the shareholder.

Agreeing on the definition of the Good Leaver mechanism can be time consuming during the negotiation of investment documentation. However, this time investment is important as it can help to ensure that all shareholders feel that the process for a potential exit has been set up fairly.

Departure of a Good Leaver 

If the Good Leaver situation is tied to a period of time and there are circumstances that trigger a Good Leaver exit, the Good Leaver’s exit may look like this:

If a Good Leaver situation is triggered:

  • during the first year of the lock-up period, they are obliged to offer the other shareholders 75% of their share in the company to the other shareholders,
  • during the second year of the lock-up period, they are obliged to offer the other shareholders 50% of their share in the company to the other shareholders,
  • during the third year of the lock-up period, they are obliged to offer the other shareholders 25% of their share in the company to the other shareholders.

As this is not a statutory provision and the wording of a Good Leaver clause is left to the discretion of the parties, the wording should always be negotiated in consideration of the particular situation in which the company currently stands. The Good Leaver mechanism that is not directed against the founders, nor against the company. It is intended to be seen as a fair agreement to protect the company as well as its shareholders. 

Author: Lenka Letková
Editors: Juraj Šándor and Maroš Čorba