In brief, Good Leaver, Bad Leaver provisions impose a penalty on business promoters who leave the business of their own volition within a specified time.
The provisions are there because investors are backing a particular management team and are keen to ensure that the team stays in place and builds value until a profitable exit can be made. Since slave labour was abolished about 200 years ago, companies wishing to retain key people have to rely on a carrot and stick approach rather than legal sanction.
The stick in this case is usually a provision requiring a Bad Leaver to transfer his or her shareholding to the other shareholders (or the company itself) at less than market value. Part of the rationale for this is that a key manager leaving will reduce the value of the company. The main reason, however, is to act as a disincentive for the individual to consider leaving in the first place.
A further consideration for investors is that, particularly in early stage companies, they often invest at a valuation that gives the promoters significant sweat equity. In effect, some of the cash invested increases the value of the promoters' equity. Investors do this to ensure the management team has a worthwhile share in the upside, but the quid-pro-quo is that the team stay the course and produce the goods.
What can promoters do to reduce the burden of bad leaver provisions?
In some cases, entrepreneurs may be able to point to other factors that ensure they will stay with the business - for instance, significant personal guarantees of company borrowings. It may also be possible to negotiate a sliding scale of discount that reduces as the business grows, as new management is added and as the promised additional value is consolidated.
My advice to promoters? Understand what is happening and why, and get good advice at the right time.