Why Leaver Provisions Matter More Than You Think In Early-Stage Deals

Leaver provisions in term sheets are an often overlooked aspect of early-stage funding deals. As a founder, you should understand their importance and that addressing them effectively secures the interests of investors and owners.

As the company grows, you’ll allot equity to employees as part of their compensation for the work they do. Equity with vesting schedules is a strategic approach many founders use to attract talent and offset high salaries. This equity, in the form of option pools, is included in employment contracts.

Stock not only helps the company conserve funds, but also motivates employees. They can take part in the ownership of what they build. Then again, each funding round also results in dilution since you’ll offer equity to investors to secure capital.

Your funding consultant will warn you about the potential downsides of excessive dilution. And why it is crucial to structure funding deals carefully. They will also assist you with examining and analyzing term sheets–particularly with a focus on leaver provisions.

What are Leaver Clauses?

Let’s start by understanding what the leaver provisions are and how they work. Leaver clauses outline how to manage the equity employees and co-founders own when they leave or exit the company. The clauses specify what happens to their stock and the applicable conditions for selling it.

Leaver provisions also include information on vesting schedules and the treatment of equity in the event of an employee’s resignation. Or, in case members of the management or workforce are terminated or found guilty of misconduct, fraud, or negligence.

Investors are specifically interested in leaver clauses and may also include some of their conditions in the term sheet. In this way, they aim to secure their interests and maintain their ownership stake in the company. Their objective is to prevent unexpected and significant dilution in the event of an employee or founder exit.

Leaver provisions are crucial during funding, mergers, and acquisitions deals. Potential investors and partners will examine the existing provisions you’ve instituted and suggest adding some of their own. On your part, you’ll ensure that the company’s equity structure is secure.

You’ll want that ownership to remain in the hands of the people who actively contributed to building the company. This is why you’ll design the leaver clauses to create a balance between the interests of the investor and the owner. Investors are open to offering capital only if they’re confident of their stake.

Leaver provisions make a clear distinction between “good leavers” and “bad leavers.” They define the terms that allow equity owners to repurchase or forfeit their shares. From the investors’ perspective, they’ll want to include clauses for existing and future equity owners if they are onboarded.

Do keep in mind that term sheets are open to negotiation, and you can aggressively defend your ownership stake in the company.

How Leaver Provisions Work?

When designing the framework of leaver clauses, ensure you have expert legal counsel on board. They will assist in drafting the provisions to secure the company, maintain its stability, and align with its goals. Rely on them to ensure that all the parties involved receive fair and equitable treatment.

Don’t lose sight of your core objectives. As mentioned earlier, you’ll want to use equity as incentives for key employees. You’ll reward their commitment to the startup’s long-term success and growth. At the same time, you’ll convert your ownership stake into shares to protect controlling rights.

Leaver provisions are also essential to secure the company’s cap table. You’ll reallocate stock to employees who are actively contributing to the company. Or, to attract fresh talent as part of their compensation packages. At the same time, you also want to protect the equity if they leave.

This is where vesting schedules come in. Vesting determines the timeline in which equity rights convert into actual stock and typically ranges from three to five years. Vesting may also include a cliff period of 12 months. The remaining equity is vested over two to four years.

Assuming you’ve instituted a five-year vesting period, employees and management can exercise their options over a 48-month period. Each month, they can unlock 1/48th part of their shares. The stock they claim is the vested shares, and the remaining shares are termed unvested shares.

Leaver provisions outline what happens to the balance unvested shares if cofounders, management members, or employees “exit” the company. That’s where good leaver and bad leaver clauses come in. They specify the number of shares exiting people can keep, their value, and applicable conditions.

Your legal counsel will ensure that they use the correct terminology to clearly explain the conditions and eliminate any ambiguity.

Good Leaver Provisions

Good leavers are individuals who exit the company for reasons beyond their control and do so on favorable terms. You’ll allow them to retain the shares they’ve already vested or sell them in the open market at fair value. The typical reasons why they may choose to leave include:

• Redundancy of their roles or positions in the growing company
• Severe physical or mental conditions that hamper their ability to continue working
• Death or retirement since they have reached the retirement age
• Death or serious illness of a family member, spouse, or child
• Voluntary resignation as required by investors, owners, or the board
• Inability to continue performing per the company’s requirements for reasons beyond their control. For example, COVID-19.
• The company dismisses them unfairly.

Bad Leaver Provisions

Bad leavers are individuals whose actions have caused damage and/or losses to the company. They exit the company on unfavorable terms, which is why the board may take action for their equity. The leavers may have to forfeit the unvested shares.

Any forfeited shares are returned to the options pool to be allotted to new hires. This strategy enables companies to minimize dilution and secure company stock by eliminating the need to issue new shares.

If they have already vested shares, the company may offer to repurchase them at a discounted or nominal rate. The price is typically lower than the market value as part of the penalty, depending on the nature of the transgression.

Here are some of the reasons why the company terminates their services.

• Fraud or gross misconduct
• Poor performance and failure to meet their targets
• Bankruptcy
• Leaving the company before completing their pre-determined milestones
• Disqualification from a director’s role
• Breaching the shareholder agreement
• Resigning despite being asked to stay on

Do keep in mind that leavers need not necessarily be good or bad, and there’s often a grey area. The board may use its discretion in managing and negotiating the stock allotted to the exiting individual.

Considerations When Designing Fair and Equitable Leaver Provisions

Aside from securing the company’s cap table, the framework of leaver provisions sets the tone for the company culture. Employees know what to expect and the treatment they’ll receive when they leave.

Fair leaver provisions effectively attract and retain talent, while also protecting the cofounders’ stake in the company. Here are some key considerations to keep in mind when drafting the clauses.

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Individuals Should Feel Free to Leave

Recognize that companies are dynamic organizations with frequent new hires and exits. The growing company may not be a suitable environment for employees who prefer to work in smaller companies. Or, cofounders may want to move on to new projects and start companies.

Unfair leaver provisions may force them to stay on even though they no longer contribute adequate value to the company. This factor could work against the company’s interests and growth structure.

Work with your legal counsel to eliminate any clauses that make it difficult for individuals to opt out. Secure the company’s culture so they walk away voluntarily when they are no longer a good fit. But with the rewards they deserve for scaling the company to this point.

When you’re ready to hire new talent, the anticipation of stock options and attractive compensation structures will act as incentives. On the other hand, leaver clauses should also serve as warnings against bad behavior. Employees should understand the risks of leaving in bad faith.

Vesting Schedules Should be Monthly

Most companies permit employees to vest their stock options every month, rather than quarterly or annually. This practice has several advantages, particularly in the context of restricted stock units (RSUs). Employees have the incentive to stay longer in the company and contribute to its success.

From the management perspective, they need to release equity gradually, which lowers the risk of large equity payouts. This situation can arise if the employee chooses to exit the company shortly after vesting their options.

Employee retention is assured, and both–the management and employees–have predictable vesting schedules to handle.

The Investor Perspective

Leaver provisions would also account for future fundraising programs and attracting capital. When examining these clauses, investors require assurance that the founders will remain with the company for an extended period. They also prefer milestone-centric vesting schedules for employees.

Remember that more than companies and their fundamental concepts and IPs, investors bank on the people behind the scenes. Company owners and teams with adequate motivation will undoubtedly commit to its long-term success.

Investors often require extensions on unvested shares for founders in their term sheets. That’s one strategy to ensure that you’ll align with the investment horizon they intend for the company.

Leaver provisions are only one of the many aspects of a term sheet. If you’re for more information about these proposals and how to navigate them, check out this video I created.

Founder Leaver Clauses are Different from Employee Leaver Clauses

Leaver provisions for founders are typically designed differently from those of employees. The compensation structure for founders comprises a significant percentage of equity. Stock is how they repay themselves for the personal funding, time, and effort they dedicated to building the company.

Unlike employees who receive a regular paycheck, it’s not unusual for founders to forego withdrawing salaries to conserve scarce resources. Or, they may take salaries well below industry standards. Once the company is stable, the board allocates their net worth in equity.

This is why leaver provisions are different for founders. They cannot lose their compensation when leaving the company, even if they don’t remain until it is sold. Or enters into a merger or acquisition (M&A), or goes to an initial public offering (IPO).

You have the right to reap the benefits of a successful exit to offset the years of risks you took. Thus, leaver provisions for founders are considered good leavers by default. When negotiating clauses in the term sheet, be cautious of predatory clauses that investors may propose.

Work with your legal counsel and fundraising consultant to understand precisely how much stock you can safely offer for capital. Calculate the potential dilution in your ownership stake since you risk losing controlling rights in the company.

Don’t be in a position where investors oust you from the company or relegate you to lower positions. At the same time, secure your stake so you can exit the company when you’re ready to explore new options. The possibility of losing compensation should not deter you from moving to fresh pastures.

Accelerated Vesting Clauses

While exploring leaver provisions and how they work, you’ll factor in accelerated vesting clauses. These clauses can be of two types: single-trigger acceleration and double-trigger acceleration. Here’s how they work:

• Single-trigger acceleration: This is a predetermined event that results in all the unvested shares the founder owns converting into vested shares instantly. The events can include a liquidity event, like the sale of the company. Although this trigger is applicable only to founders, the board may choose to award accelerated vesting to select employees. Of course, the trigger occurs only in a liquidity event, but it may be subject to additional conditions.
• Double-trigger acceleration: This acceleration occurs when two triggers are present. One of these should be the standard liquidity event, such as a sale or acquisition. The other can be a good leaver clause. For instance, when the individual’s job becomes redundant in the company.

In Conclusion!

Clearly outlining leaver provisions in the equity structure is crucial for the company’s stability and for securing your interests. You’ll use expert guidance to draft them carefully, ensuring you attract and retain top talent. Stock options help to incentivize and motivate employees to work well.

Investors are likely to scrutinize leaver provisions since they give them an overview of the dilution to expect. At the same time, they understand the compensation structure you have in place. These factors can ultimately influence their investment decisions.

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