Giving shares to a key employee can be an excellent way to reward loyalty, incentivise performance and align an employee’s interests with the long-term success of the business.
For founders, however, the decision should be approached carefully.
Once an employee becomes a shareholder, the relationship is no longer simply one of employer and employee. The individual may acquire valuable rights as a shareholder which can continue even if their employment subsequently ends.
That can create a difficult situation.
What happens if the employee leaves after six months? What if they join a competitor? What if their relationship with the founders breaks down? Can they keep their shares? Can they sell them to somebody else? What happens if the company is sold?
Before giving shares to an employee in an Irish company, founders should ensure that appropriate protections are contained in the company’s shareholders’ agreement, constitution and other relevant documentation.
Here are some of the most important issues to consider.
The first question is whether the employee should receive all of the proposed shares from day one.
Founders may want to reward an employee with, for example, a 5% interest in the company. However, transferring the entire 5% immediately could create problems if the employee leaves shortly afterwards.
One option is to consider a vesting arrangement.
Rather than the employee receiving an unconditional economic interest in all of the shares immediately, the arrangements can be structured so that their entitlement develops over an agreed period or by reference to specified conditions.
For example, the commercial intention might be that the employee earns their equity over several years, encouraging them to remain with the company and contribute to its growth.
The appropriate structure requires careful consideration from a legal and tax perspective. Founders should obtain appropriate advice before promising or issuing equity to an employee.
The key point is simple: do not give away permanent equity without considering what happens if the employee leaves much earlier than expected.
One of the most important protections when an employee owns shares is a clear set of good leaver and bad leaver provisions.
These provisions address what happens to an employee’s shares when their employment or involvement with the company ends.
A shareholders’ agreement might provide that certain events trigger a compulsory transfer of some or all of the employee’s shares.
The agreement should carefully define the circumstances in which an individual is treated as a good leaver or a bad leaver.
A good leaver might, depending on the agreement, include somebody whose employment ends because of circumstances such as ill health, death, agreed retirement or another reason accepted by the company.
Bad leaver provisions may apply to defined circumstances such as serious misconduct or particular breaches of contractual obligations.
The distinction can have major financial consequences.
The price payable for shares may differ depending on the circumstances in which the employee leaves. The drafting should therefore make clear both when a compulsory transfer is triggered and how the shares will be valued.
Poorly drafted leaver provisions can themselves become the source of a substantial shareholder dispute.
Founders should also consider what happens if the employee wants to sell their shares.
Without appropriate share transfer restrictions, the founders could potentially face an unwanted change in the ownership structure of the company.
The shareholders’ agreement and constitution should therefore be reviewed to ensure there are suitable controls over transfers.
These may include pre-emption rights, under which shares must first be offered to existing shareholders before they can be transferred to an outside party.
The documentation should address questions such as:
These provisions can help founders retain control over who becomes a shareholder in the company.
Giving somebody shares does not necessarily mean that they should have the same influence over every company decision as the founders.
Before issuing shares, consider exactly what rights will attach to them and how the employee’s shareholding interacts with the company’s existing governance arrangements.
A shareholders’ agreement commonly contains reserved matters requiring a specified level of shareholder approval.
These might include:
Founders should consider whether introducing an employee shareholder changes the voting dynamics for these decisions.
This becomes increasingly important as more employees or investors acquire shares.
A company that began with two founders may eventually have several minority shareholders. The governance arrangements that worked when there were only two shareholders may no longer be appropriate.
A key employee may have access to some of the company’s most valuable information.
This could include:
If that employee is also becoming a shareholder, the founders should review the company’s confidentiality provisions and restrictive covenants.
Depending on the circumstances, restrictions might address competition with the company or solicitation of employees, customers or suppliers.
However, restrictive covenants require careful drafting. Their enforceability cannot simply be assumed, particularly where restrictions are drafted more widely than is reasonably necessary to protect legitimate business interests.
The employment contract, shareholders’ agreement and any separate agreements should also work together rather than contain inconsistent obligations.
For many modern businesses, the most valuable assets are not physical.
They may be software, designs, processes, databases, brands, inventions, content or other forms of intellectual property.
If a key employee has played an important role in developing those assets, founders should ensure that the company has appropriate documentation dealing with ownership of intellectual property.
This issue should ideally be addressed before shares are issued.
A valuable company should not discover during an investment round, shareholder dispute or proposed sale that there is uncertainty about whether important intellectual property actually belongs to the company.
Imagine the founders receive an offer to sell 100% of the company five years after giving shares to a number of key employees.
Will those employee shareholders be required to sell?
A properly drafted shareholders’ agreement may contain drag-along provisions.
These can allow a specified majority of shareholders, in defined circumstances, to require minority shareholders to sell their shares as part of a sale of the company.
Without an effective mechanism, a small minority shareholder could potentially create difficulties where a purchaser wants to acquire 100% of the company.
At the same time, employee and other minority shareholders may benefit from tag-along rights.
A tag-along provision can, depending on its terms, give minority shareholders the opportunity to participate where controlling shareholders sell their shares to a third party.
The objective is to think about the company’s eventual exit while everyone is still aligned.
An employee who receives 5% of the company today will understandably want to know whether they will always own 5%.
The answer may be no.
The company may subsequently raise investment or issue shares to other employees. New share issues can result in existing shareholders owning a smaller percentage of the enlarged share capital.
The shareholders’ agreement and constitution should therefore deal appropriately with new share issues and pre-emption rights, having regard to applicable company law.
Founders should also consider future employee incentive arrangements.
If the company expects to award equity to several employees over time, it may be preferable to plan the overall structure rather than negotiate an entirely new arrangement each time somebody is offered shares.
A common mistake is to treat the employee’s employment and shareholding as entirely separate matters.
In reality, the documents can interact.
Suppose the employment contract allows the company to terminate employment but the shareholders’ agreement contains no effective mechanism requiring a departing employee to transfer their shares.
The company could end up with a former employee who no longer has any role in the business but continues to own a significant shareholding.
The reverse problem can also occur where different agreements contain inconsistent provisions concerning termination, restrictive covenants or the circumstances in which shares must be transferred.
The relevant documentation should therefore be reviewed together.
This may include:
The commercial arrangement should be clear across all of them.
One of the most contentious questions in any shareholder exit can be:
What are the shares worth?
Suppose an employee received shares when the company was worth €1 million.
Five years later, the company may be worth €10 million.
If the employee leaves, must they sell their shares? If so, at what price?
The shareholders’ agreement should consider the share valuation mechanism.
Questions might include:
There is no universal answer appropriate for every company.
What matters is that the parties understand the consequences before the shares are issued, rather than discovering them for the first time when the employee is leaving and relations may already have deteriorated.
Giving an employee shares without reviewing the company’s shareholder arrangements can create significant difficulties later.
The employee does not automatically cease to be a shareholder merely because they resign or their employment is terminated.
This is a particularly important point for founders.
Ending somebody’s employment and recovering their shares are separate issues.
Whether shares can be compulsorily transferred will depend on the applicable legal and contractual arrangements.
If there is no effective compulsory transfer mechanism, the founders could find themselves continuing in business with a former employee as a minority shareholder.
The company’s constitution, Companies Act 2014 and other relevant agreements will then need to be considered.
This is why the shareholder arrangements should be addressed before equity is given to an employee.
Founders should not assume that shares can simply be “taken back”.
Shares are an ownership interest in the company.
If the commercial intention is that an employee must transfer their shares when they leave, appropriate arrangements need to be put in place to deal with that situation.
The documentation should clearly address the circumstances triggering a transfer, the identity of the purchaser and the basis on which the price will be determined.
Trying to agree these issues only after an employee has left can lead to a shareholder dispute over ownership, valuation and the enforceability of the relevant provisions.
Founders considering giving equity to a key employee should also consider whether an immediate issue or transfer of shares is actually the most appropriate structure.
Depending on the circumstances, alternatives may include share options or other forms of employee incentive arrangement.
Each structure can have different legal, commercial and tax consequences.
The appropriate solution will depend on matters such as the company’s stage of development, the objective of the incentive, how long the employee is expected to remain with the business and the founders’ plans for investment or an eventual sale.
Specific legal and tax advice should therefore be obtained before implementing an employee equity arrangement.
Giving shares to an important employee can create a powerful incentive.
But founders should not focus exclusively on how the employee becomes a shareholder.
They should also ask what happens afterwards.
Before giving shares to a key employee, founders should consider:
The best time to agree these matters is generally when the founders and employee are enthusiastic about working together.
Waiting until the relationship has deteriorated can make the same issues considerably more difficult and expensive to resolve.
Sherwin O’Riordan Solicitors advises founders, companies, investors and shareholders on shareholders’ agreements and employee share arrangements in Ireland.
We can advise on shareholder protections including good leaver and bad leaver clauses, share transfer restrictions, pre-emption rights, vesting arrangements, reserved matters, drag-along and tag-along provisions, shareholder exit mechanisms and share valuation provisions.
We also advise companies and shareholders when disputes arise concerning the ownership, transfer or valuation of shares.
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