Kate Schmit and Nicholas Atkins look at the use of good leaver/bad leaver provisions to incentivise employees, and suggest that the use of discretion to allow for “intermediate leavers” can benefit the organisation.
Employee share ownership resources
What are good leaver/bad leaver provisions?
These are provisions that deal with what happens if an employee leaves; they are typically found in contexts such as contractual bonus arrangements, earn outs and share option schemes, as well as investment agreements and companies’ articles of association.
These provisions seek to identify particular categories of employee by the reason for their departure. Whether they are then categorised as a “good” or “bad” leaver may impact whether or not they:
- receive any element of accrued bonus or earn out up to the date of cessation of employment;
- retain or lose share options or other equity incentives; or
- retain any shares in the employer company that they hold or, if required to sell those shares, the price they receive.
Often when the employer sets the good leaver/bad leaver provision, the balance of power between the parties is such that there is little opportunity for the merits of the good leaver/bad leaver formulation to be discussed between employer and staff. The leaver provisions are unilaterally set by the employer – take it or leave it.
In contrast, leaver provisions in investment agreements in private equity-backed management buyouts tend to be closely negotiated.
Such provisions are highly tailored to incentivise (or penalise) particular behaviours or the performance of the management team.
What is a good leaver?
The starting point for share options and bonuses is often “you leave, you lose”. This can result in a draconian outcome for employees who leave employment through no fault of their own.
For this reason, an employer may distinguish between “good” and “bad” leavers, with a standard approach applied throughout its incentive arrangements. The Investment Association Principles of Remuneration suggest that typical examples of “good” leaver reasons are:
- disability or ill health;
- retirement; or reasons analogous to those above.
Careful thought should be given to how these criteria will work in practice. For disability or ill health, for example, there should be clarity about what sort of ill health qualifies for “good” leaver status and who determines whether or not it applies.
In any event, dismissals for disability or ill health risk claims for disability discrimination, so “good” leaver provisions should not be looked at in isolation.
Organisations should also consider whether or not “retirement” should be included as a standard good leaver reason and how to define it since the abolition of the default retirement age.
Giving “good” leaver status to those retiring risks treating younger leavers less favourably because of age, and so will be age discriminatory unless it can be objectively justified.
What is a bad leaver?
This therefore raises the question: “How bad must a bad leaver be?” There is no hard and fast rule.
A bad leaver may be a person whose employment has been terminated summarily for cause; but it could be broader than this to also catch someone joining a competitor or any resignation which falls outside the “good” list.
Somewhere in between: discretionary or intermediate leaver
The good leaver/bad leaver tag can be too binary, however.
Employers may want additional flexibility to deal with employees as individuals and to identify one-off situations. In such a case, it is possible to include a discretionary good leaver provision so that the employer can deem someone a “good leaver” even if they fall outside the standard reasons.
Case law demonstrates that employers must exercise such discretion in a bona fide manner and not in a perverse or irrational manner.
A board or remuneration committee should consider carefully how they exercise discretion on this. For example, does it create a precedent? Has discretion been exercised in a discriminatory way or in a way that might reward failure?
Any decision should be fully documented, reasonable and should be subject to some degree of oversight to check for consistency.
Private equity transactions make significant use of the concept of “intermediate” or “early” leavers, which can diffuse the “good” or “bad” leaver tag.
For example, the price achieved for a leaver’s share might be influenced by the point at which they leave the company – someone leaving three years or more after the investment may get a better price than an early leaver – or by the performance of the business before their departure.
This results in a targeted, ratchet impact for the leaver, designed to align behaviour with the requirements of the investor.
Used with care, leaver provisions can be a useful method of retaining talent and discouraging misconduct. However, the binary nature of “good” or “bad” has its limitations and can produce a harsh outcome for employees who may have significantly contributed to the business over a medium-term period.
Introducing “intermediate leaver” provisions can help develop a more sophisticated approach, providing the employer with a powerful tool to incentivise and encourage performance over a longer term.