This is a topic fraught with complexity; legal (what is the impact of company and employment law?), financial and commercial (what is the loss/cost to the business?) and emotional (how are the management leavers in question behaving/going to behave, and how will other managers and employees react?).
1. Employment law
Any executive director such as a CEO, COO or CFO (as opposed to a non-executive director, who is not performing a permanent role in the company day-to-day) will be an employee, and the terms of this relationship will be documented in a ‘service’ or employment contract. The resignation or removal of that director will therefore require the termination of their status as an employee.
At law, the cessation of a director’s employment is no different to the cessation of any other employee’s. This means that any resignation must comply with the manager’s service contract, and any dismissal should comply with (i) the director’s service contract, (ii) the company’s applicable employment and disciplinary policies (typically contained in an employee handbook), and (iii) applicable employment law.
In the case of a dismissal, the company and the investor will have to tread carefully to minimise any risk of a subsequent claim by the director, for example for breach of the service contract or unfair dismissal. Legal advice should be sought, as there are many surrounding factors to consider. To highlight but a few, has the director been warned of any prior underperformance, made any prior complaints (including whistleblowing), been suffering from illness or a disability, requested maternity/paternity leave or been asked to perform tasks which deviate materially from their initial job specification? Often, to short-cut the formal disciplinary/dismissal process that would be followed for a more junior employee, some kind of enhanced package is proposed.
In all but the most harmonious departures, the company and the investor will typically want to reach an agreed settlement with the departing director, including a waiver of all claims relating to their departure. Note that it is a legal requirement of any valid settlement that the departing individual receives independent advice (e.g. from a lawyer) and that this is recorded in the settlement agreement.
2. Corporate governance
It is important to distinguish between termination of an executive director’s status as an employee (as discussed above), and termination of their statutory position as a director. In the UK a company’s (or an investor’s) ability to remove an individual as a director will depend on the terms of the relevant company’s articles of association, any shareholders’ agreement governing the company and the default provisions of the Companies Act 2006.
Well-drafted articles of association will, where there is a majority investor, typically allow that majority investor to remove or appoint directors by notice to the company (and the shareholders’ agreement will mirror this). However it is advisable to review both documents in detail in case any other arrangement was reached; for example granting an individual a right to remain a director so long as they hold shares, or giving a category of minority shareholders a veto right over that individual’s removal.
If the articles of association and shareholders’ agreement do not prescribe a simplified process for removal (e.g. majority shareholder notice), the Companies Act 2006 provides a procedure to remove a director by resolution of over 50% of shareholders. However such a resolution requires ‘special notice’ to the shareholders (28 days), and notice must also be sent to the individual in question. The individual then has a right to require the company to circulate his written objections to the shareholders or have them read out at the relevant shareholder meeting.
The simpler solution then – in any situation – is often for the individual to resign their directorship rather than be removed. Even in an acrimonious situation, that may be possible if the individual’s service agreement contains a provision requiring the individual to resign from all directorships as soon as their employment is terminated. This should be included in any well-drafted service agreement, and should be reinforced by a power for any representative of the company to sign a resignation letter on the individual’s behalf, should they refuse to do so.
3. Retention/disposal of shares and share options
At the same time as settling an individual’s employment and directorship status, it is important to consider how any shares or share options held by that individual should be treated. Share options typically lapse on termination of employment, but ownership of shares can be more complicated.
An institutional investor should have negotiated compulsory transfer (or ‘leaver’) provisions with the managers at the time of investment. These are likely to be set out in the company’s articles of association, and provide a window during which the majority shareholders or the company can (but is not obliged to) trigger the compulsory sale of some or all of the leaver’s shares. The articles of association often limit who can be a buyer, or may even provide a hierarchy – e.g. the leaver’s shares must first be offered to other managers, then offered for the company to buy-back or place into an employee benefit trust, and then (usually bottom of the list) to the institutional investor.
It is quite possible to agree that management leavers should retain some or all of their shares, but that can store up difficulties for an eventual sale process. At a minimum the investor and company should ensure that voting rights do not survive the leaver’s departure. The articles of association may already provide for this.
4. Share price and valuation
If a leaver has agreed, or is required, to sell some or all of their shares, the next challenge is to determine the share price. That will typically be governed by the terms of the shareholders agreement and/or articles of association, and will depend on the circumstances of the leaver’s departure. Management leavers are usually classified as either a ‘good’ or ‘bad’ leaver; ‘bad’ including resignation, breach, and grounds justifying summary dismissal, and ‘good’ including death and permanent bad health – the middle ground is subject to negotiation.
‘Good leaver’ share price is typically market value, and ‘bad leaver’ price is typically the lower of market value and the amount paid for the shares. Be careful to check the articles of association for concepts of ‘vesting’ though; if ‘vesting’ applies only a specified proportion of the leaver’s shares (based on time elapsed since acquiring the shares) may be eligible for ‘good leaver’ price. Market value is typically defined as a price agreed between the leaver and the company, representing what a willing seller and a willing buyer would agree on the open market. This test, being hypothetical, does create potential for disagreement, so if the company and the leaver are unable to agree on a ‘market value’ this is typically referred to a third party expert (an accountant) for determination their behalf.
Once share price has been settled, the terms and price of any sale can be incorporated into a settlement agreement with the management leavers, providing a ‘clean break’ for all involved.
5. Security for earn-out payments
Even after the relevant individual has left the company (and potentially also ceased to be a shareholder), their behaviour can continue to impact on the company. To mitigate the risk of the management leavers strengthening a competitor, or soliciting clients or employees away from the company, the management leavers should have been required to sign up to restrictive covenants (non-competes and non-solicits) in their service agreement and any shareholders’ agreement.
The duration and scope of such covenants is typically more favourable (to the company) in the shareholders’ agreement, as the relative bargaining power between shareholders should be more equal than that between an employee and employer, which improves the enforceability of longer and more onerous restrictions.
Any leaver should be reminded of these covenants as they depart the company, and it may be prudent for them to be reaffirmed. If there is any indication that the leaver has breached or is likely to breach them, or the leaver is claiming they are unenforceable, the company should seek professional advice on the rights and options available to it.
With special thanks to Daniel Pollard, Partner at GQ Littler, a specialist employment law firm that works closely with the team at MJ Hudson, who provided employment law input for this article.
Is this brief too brief? Do you need any help with changes to an investee company’s management team? Expert legal advice is on hand from MJ Hudson’s M&A and corporate law team.