Employment partner Stephen Ravenscroft has seen his fair share of complexities when it comes to business succession. As part of a series of conversations with partners at Wedlake Bell, where we explore succession from both personal and corporate perspectives, Steve shares his expertise on the employment law aspects that founders need to consider when taking investment or selling up. From the importance of having proper employment contracts to navigating the complexities of TUPE transfers and equity arrangements, this discussion provides valuable guidance for founders at various stages of their business journey. Join us as we uncover the critical factors that can influence a founder’s success and the strategies to protect their interests in the ever-evolving business landscape.
Steve, how can a founder be best prepared for a business sale or investment? Can you tell us what employment issues may arise and what a founder should be mindful of in those circumstances?
It really depends upon the nature of the business and the nature of the transaction that the founder is considering. Is it a very early stage investment or is this a means to an exit in the founder’s mind? There will be different factors from an employment law perspective depending upon some of those issues, the size of the business, the sector and so on. Certainly if you’re thinking about an early stage of investment, maybe it’s a tech startup that’s done tremendously well very quickly, the founder might not even have their own employment contract in place. We have certainly seen that from time to time. As a rule, any investor will want to know going forward that the founder and other key members of senior management have proper employment contracts containing customary terms to protect the business, including notice and garden leave provisions, confidentiality and IP obligations and restrictive covenants.
So it’s likely that the founder will be presented with a new employment contract (sometimes called an executive service agreement) on which they will need to take legal advice.
If the transaction is structured in a way that results in a transfer of assets, then that could trigger a TUPE transfer (which protects an employee’s terms and conditions of employment) and this might be something totally new for the founder and for the founder’s colleagues. That may well require the founder and other senior managers to enter into settlement agreements too. And that would particularly be the case if, for example, their current employment arrangements are being replaced by new employment arrangements going forward.
So once again, that will be the type of document that the founder would need to take legal advice on. In fact, it is a condition for a settlement agreement to be binding and enforceable that the employee has taken independent legal advice on its terms and effect. So, they’re the types of issues that the founder might need to think about purely from an employment perspective about their own situation.
But then, more widely, they’ll need to be thinking about their HR structures across the business. Are they going to be fit for purpose for the growth that’s expected if it’s an early stage investment? Or are they already fit for purpose to make it attractive for a buyer if it’s a full exit? And so, it could be important for the founder and for the founder’s team to conduct an audit all of their HR structures currently in place. And that will include things like clear job titles and roles, accurate job descriptions, appropriate policies and procedures, well-maintained payroll records, appropriate remuneration and incentive strategy, effectively all of the HR hygiene that you would want to see in a developed business.
Straying slightly out of the strict employment sphere, the founder will of coursed need to agree arrangements around their equity and what’s going to happen to it. If it’s a sale, are they going to receive their full consideration up front, or will some of this be deferred dependent upon future performance of the business? If it’s an early stage investment where they’re continuing to remain an important shareholder within the business, what class of shares are they going to hold? Will they hold different classes of shares? What are the terms attached to those shares? There’s likely to be a sale and purchase agreement (SPA), a shareholders agreement (SHA) and/or an investment agreement (IA) depending upon the nature of the transaction. And amongst all the other commercial and corporate items that they’ll need to be advised upon there, there’ll probably be provisions around what happens to their equity on departure, and this may be dependent upon the reason for their departure.
That’s when you often hear people talking about “good leaver” and “bad leaver” clauses, definitions of termination without “Cause” or termination for “Cause”, and so on.
Tell us more about this idea of good leaver, bad leaver? Does that tie in to potential forced exits? What could you do to protect yourself if it’s looking like you’re going down that bad leaver route?
Yes, the important thing is for the founder to be really on the ball when negotiating these terms in the transactional documents, so that they are fully aware of the potential outcomes further down the line.
An investor/buyer will often want to define good leaver provisions in a very narrow way. So for example, they may say a “good leaver” is somebody whose employment ends due to death, serious disability or ill health, retirement or redundancy (often with some discretion built in for the investor for other unforeseen circumstances). And in all other circumstances, the departing shareholder is deemed a “bad leaver”.
Whereas, it makes a lot more sense for a founder to negotiate the specific areas where they would be deemed to be a “bad leaver” and provide that in all other circumstances they would be deemed to be a “good leaver”. “Bad leaver” reasons often include voluntary resignation and any kind of summary termination for misconduct, gross misconduct or gross negligence. Sometimes the summary termination reasons are given a separate definition of “Cause”.
What is a forced exit and why do they happen?
If it’s a forced exit, that is to say a unilateral decision that the founder has to leave, that most commonly arises in two types of situations.
The first is where the business is not performing to the satisfaction of the investor and they feel that they need a new CEO, a new management team, new leadership in place. And the second is where there’s a fallout between the founder and the investor. Sometimes both of these situations apply, but not always.
So, what can a founder do to protect themselves in those situations? Well, taking the first of those, clearly performance is subject to all sorts of factors, and some of them may be totally out of the control of the founder. But what they can control and influence are the human aspects of the business.
So, making sure that they have the right people in place who understand their roles and are incentivized to perform to the best of their ability is key. And there could be a variety of things that facilitate this, such as making sure there are clear job descriptions in place, people understand what their role is and they have clear business objectives and targets, both individually and collectively. That way everybody knows what they are striving for.
And on the incentivization piece, something that is performance-related, whether that’s connected to individual and/or company performance, will be essential. We often see that, in most cases, a successful founder will take key personnel with them on their journey and that might mean sharing some of the equity, ensuring that the really key people are suitably incentivized to make the business a success for everybody’s benefit.
It’s a bit trickier when you’re talking about a founder falling out with an investor. There could be a variety of reasons for that too, whether that is conduct or performance related or otherwise.
Ultimately, in those circumstances, it’s probably going to be necessary for the founder and the investor to seek some kind of alternative dispute resolution as it is very rarely in either party’s interest to go to court. Either a mediation or arbitration or some kind of negotiated settlement around how their employment and their shareholding will be treated on exit is most often preferable to litigation.
Find part two here.