Leave under a cloud leave shares behind

By Swathi Girimaji, Bharucha & Partners

Bad leaver provisions are often included in shareholders’ agreements in start-ups, particularly up to series C rounds of funding. Their purpose is to discourage a founder from leaving the business after raising institutional investment by putting their equity at risk. Clauses are usually structured so that the founder’s equity is unlocked, and capable of transfer, over a period, referred to as reverse vesting. Locked and unlocked equity are treated differently depending on whether the founder leaves on good terms or bad.

Swathi Girimaji, Bharucha & Partners
Swathi Girimaji
Bharucha & Partners

A founder is deemed a bad leaver if their employment is terminated for misconduct, fraud, embezzlement related to the company’s affairs, commission of an offence involving moral turpitude or breach of material provisions of the shareholders’ agreement. The last includes not obtaining investor consent for reserved matters and breaching transfer restrictions or non-compete obligations. Founders try to limit offences to those relating to the company and exclude those committed in their personal capacity. More recently, and likely in response to Travis Kalanick’s leaving Uber, sexual harassment is considered a ground for treating a founder as a bad leaver.

Conversely, a good leaver is a founder who separates from the company either because of unjust treatment by the company through no fault of their own or who leaves on agreed terms. While the inclusion of good and bad leaver clauses is widely accepted, the triggers for treating a person as a bad leaver and their consequences are heavily negotiated between the investor and the founders.

Founders argue that they should not be treated as bad leavers unless there is an adverse finding by a court. This stems from their apprehension that, in India, any person can easily make false allegations and frame the founder. Baseless allegations, they contend, should not lead to drastic adverse consequences. On the other hand, due to the protracted nature of Indian court proceedings, investors prefer not to wait for a court order. If the allegations prove to be true, the company will have been exposed to a delinquent founder, who could further drain its resources in addition to exposing the investor to reputational risk. As a compromise, parties usually agree that the trigger is the filing of a charge sheet plus a reasonable period during which the case may be dropped. Another solution is for the trigger to be the adverse finding of an independent body appointed by the board and without the participation of the founder, following a forensic audit. The founder could also be put on leave until the investigation is completed, as in the case of Ashneer Grover at BharatPe.

Being classified as a bad leaver often involves the forfeiture, buyback or purchase of the departing founder’s locked and unlocked equity at the cost of acquisition. In some cases, parties agree to different treatment for locked and unlocked equity depending on the trigger offence. A more lenient consequence follows unintentional breaches, with harsher consequences for fraud or wilful misconduct. Founders sometimes argue that their equity should be purchased at a fair market value rather than the cost of acquisition, as the value of the equity will likely have depreciated if their conduct has adversely affected the company. This ensures that there is a proportionate impact on the founder. While this argument holds good for financial offences, it does not work for offences like sexual harassment. Further, even if the financial impact on the company is not significant, it is arguable that bad behaviour with bad faith should have a disproportionate consequence, thus serving as a meaningful deterrent.

It is crucial for parties to negotiate bad leaver clauses carefully to ensure that they are enforceable. Factors such as the number of founders in a company, the age of the company, the cost of acquisition of shares and the size of the stake all play a significant role in determining the consequences of bad leaver clauses and the duration of the reverse vesting. Enforcement, such as a buyback which requires the cooperation of the bad leaver is more challenging than a call option by an employee stock option plan trust or new founder or a specific investor. Founders must understand the implications of such provisions before accepting them in the course of raising funds.

Swathi Girimaji is a partner and Varsha Singh is an associate at Bharucha & Partners.

supreme court

Bharucha & Partners

Purva Premiere Residency Road Bengaluru,
Karnataka 560025. India

Contact details:

Tel: +91 80 4614 5993

Email: sr.partner@bharucha.in