Key Executives – Some Protections for Investors

September 4, 2014

As lawyers specialising in corporate law, we often advise institutions and individuals keen to invest in businesses, or investee companies seeking such investment.  In many cases, the investee company has one or more executives whose continued involvement in the business may be a crucial part of the investment decision.  Here are some of the protections which an investor may seek in those circumstances.

Investor Control

Usually, the investee company and all its shareholders (including the investor) will enter into an investment/shareholders’ agreement when the investment is made.  Often, this sets out specific matters which cannot be undertaken without the prior approval of the investor, including the hiring or removal of key executives, or the alteration of their remuneration or other material terms of their employment. 

The investment/shareholders’ agreement (and the investee company’s constitutional documents) may also provide that upon the occurrence of specified events (such as the departure of a key employee), the investor’s rights will be enhanced (for instance, by increasing voting rights at board/shareholder level, and entitling the investor to require accelerated repayment of any debt or preference share capital provided by it to the investee company).

The purpose of these provisions is not of course to enable the investor to interfere with the management’s conduct of the business of the investee company, but rather to ensure that the investor can step in (and exercise greater executive influence) if there are significant changes at the executive level which may potentially threaten the value of the investment.

Restrictive and Other Covenants

The investment/shareholders’ agreement (and senior employees’ service agreements) should also contain restrictive covenants, which prevent shareholders/key employees from competing with the company, or from poaching the company’s customers, suppliers and staff. Restrictive covenants last for a specified period after they leave the company (usually up to 24 months).  Both the investor and the investee company should also ensure that service agreements contain gardening leave provisions, so that if a key employee leaves, he can be required to serve out his notice period away from his place of work – this reduces the opportunity for the employee to solicit business for a new employer by contacting the company’s existing customers/suppliers, or misusing the company’s confidential information or intellectual property prior to his departure.

These provisions require careful drafting to ensure, so far as possible, that they are legally enforceable.

Financial Disincentives

Usually, the constitutional documents of an investee company contain provisions requiring departing employees who are shareholders to offer their shares for sale, to the other continuing shareholders and, sometimes, to the company itself.  This is important, from the perspective of both investor and investee company, in order to ensure that former employees do not participate in the growth of the investee company after they leave and cease to contribute.  These so-called “leaver provisions” usually differentiate between a “good leaver” and a “bad leaver”, depending on the circumstances of their departure.  Although there are many variables, usually employees who are severely unwell or die during the period of their employment,  or who are unlawfully dismissed by the investee company are categorised as ‘good leavers’, whereas employees who leave for any other reason are categorised as “bad leavers”.  The important differentiator is that “good leavers” are usually entitled to receive market value for their shares, but “bad leavers” may only receive the face or par value of their shares or the amount they paid for them when they were acquired.

In some cases, the constitutional documents will enable the investee company (and/or its continuing shareholders) to “claw back” part of the purchase price paid to a departing employee, where that employee was treated as a “good leaver” on departure but subsequently became “bad” by joining a competitor, in breach of the restrictive covenants contained in his service agreement or the investment/shareholders’ agreement.

Where a departing executive holds options (but not existing shares) in the investee company, an investor will usually expect the options to lapse automatically on departure – again, to avoid any former employee having any continuing stake in the future business.

Conclusion

In summary, although there may be scope to negotiate the detail of some of these restrictions with an investor, generally management and the investee company should recognise that many of these requirements are a necessary by-product of obtaining external investment.  Ultimately, the motivation of an investor to insist upon these provisions is to protect the value of their investment, rather than using them as a means of interfering with the management of the business. Further, in most cases, these protections are in the commercial interests of the investee company and its other shareholders, as well as the investor.


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