A Practical Guide to Private Equity Transactions
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Employment terms
choose to breach the employment contract by failing to give due notice and not
making a PILON. In these circumstances, the manager would have a claim
for damages, reecting their loss of salary and benets for the relevant notice
period. However, the manager would have a duty to mitigate (i.e. take reason-
able steps to secure new employment and thereby reduce their loss of earnings
and the value of their damages claim). If the employer is not concerned about
losing the restrictive covenants in the employment contract (possibly because
it can rely on restrictions contained in the shareholders agreement that bind the
manager), it may choose to breach the employment contract on the basis that
it believes the manager will secure new employment relatively quickly, with
the result that the employer’s liability for damages is less costly than making
a PILON. A manager may seek to avoid this outcome by either making the
PILON non-discretionary (i.e. providing that, if Newco fails to give due notice
and does not have grounds for summary dismissal, it is contractually obliged
to make the PILON), or by including a separate liquidated damages clause
that sets out a pre-agreed sum which is payable in the event that Newco fails
to give due notice.
There is a risk that, if the pre-agreed sum under a liquidated damages
clause is excessive and unconscionable, it will be void as a penalty.
9
The cen-
tral question is whether, at the time the contract was negotiated, the main pur-
pose of the clause was to deter the employer from breaching the contract or to
compensate the employee for the breach. The former indicates an unenforce-
able penalty. With these principles in mind, a discount has traditionally been
applied of, say, 10 per cent to any liquidated damages calculation so that it is
easier to argue that the pre-agreed sum reects possible mitigation and is a
genuine estimate of loss. However, based on more recent case law,
10
it appears
that it is now easier to enforce liquidated damages with little or no discount in
the employment eld.
It is common to nd that the PILON is limited to salary only. The man-
ager can argue that this does not fully compensate them for the notice period.
However, the employer can argue that the salary is unmitigated (i.e. it is not
reduced if the manager secures new employment relatively quickly) and is paid
upfront (giving the advantage of accelerated receipt), and that this represents
a fair compromise. In a private equity context where the main value of the
manager’s appointment is contained in his equity participation, the manager
may be less concerned about whether the PILON is limited to salary and more
concerned as to the denition of ‘Good Leaver’ and ‘Bad Leaver’ in cases of
dismissal, and specically in this context whether the notice period is taken
into account in determining whether shares have vested.
11
9 This follows from the principles in Dunlop Pneumatic Tyre Co. Ltd v. New Garage & Motor
Co. Ltd [1915] AC 79.
10 Murray v. Leisureplay plc [2005] EWCA Civ 963.
11 See further section 2.2 above, section 4 below, and chapter 5, section 4.11.
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Employment-related issues
If a PILON clause is triggered, then the payment is viewed as a contrac-
tual debt so that an obligation on the part of the employee to mitigate his
or her losses does not apply. However, employers are increasingly including
mitigation within the drafting of the PILON. Whilst not strictly relevant in a
private equity context, applying mitigation also reects corporate governance
best practice for listed companies, and the recommendations of the Combined
Code 2008. Whilst including mitigation in the PILON will be attractive to the
employer, a manager may argue that this is inappropriate, for example by:
(a) referring to the origins of PILON clauses, i.e. they benet the employer
by enabling it to terminate early without breaching the contract, so that
it can still enforce the restrictive covenants;
(b) arguing that the quid pro quo for protecting the covenants is that the
PILON is payable in full;
(c) pointing out that a PILON does not entail a breach of contract, and there-
fore the application of mitigation is misconceived; and
(d) if the PILON is salary only, pointing out that the omission of any pay-
ment in respect of other benets (such as bonus, pension and insurance
benets) means that a substantial discount has already been applied to
the PILON.
From the manager’s viewpoint, applying mitigation to a PILON is particu-
larly objectionable if it is a salary-only PILON. To apply mitigation in such
cases means that the manager is worse off than under a general damages
claim where mitigation is applied against his full contractual remuneration
package.
2.5 Grounds for summary dismissal
Most service agreements include a summary dismissal clause, whereby an
employer will have the contractual right to dismiss an employee without any
period of notice in certain circumstances. This right will be implied into the
contract where, for example, the employee has committed gross misconduct
or is grossly incompetent. These implied rights are construed narrowly by the
courts, however, and as a result most investors will require that Newco has
an express right to summarily dismiss an employee on the basis of broader
grounds under the terms of the manager’s service agreement.
As discussed in more detail in section 3.4 below, depending on the de-
nition of ‘Good Leaver’ and ‘Bad Leaver’, a summary dismissal may have a
substantial impact on the manager’s equity vesting. In addition, the drafting of
the grounds for summary dismissal will impact upon the manager’s nancial
package on termination, in that it will negate the need for the employer to place
the manager concerned on paid garden leave for a period or to make a PILON.
The express grounds for summary termination are largely similar to those
found in service agreements for senior directors outside private equity. For
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Employment terms
example, the service agreement may provide that the manager can be summar-
ily dismissed if he or she:
(a) is guilty of gross misconduct, gross incompetence or any wilful neglect
in the discharge of their duties;
(b) commits any material or persistent breach of their service agreement;
(c) fails to perform their duties to a reasonable standard (usually based on
the opinion of the board);
(d) is guilty of fraud or dishonesty, is guilty of a criminal offence (other than
a minor trafc offence), or otherwise brings the group into disrepute;
(e) is disqualied from holding ofce as a director under the Company
Directors Disqualication Act 1986;
(f) is admitted for treatment under any mental health legislation.
Whilst such provisions are always subject to a degree of sense check and nego-
tiation, particularly where there is any requirement for the board to reach a
conclusion on the conduct of the individual, they can prove particularly con-
tentious in private equity transactions. Rightly or wrongly, managers are often
more wary of private equity investors than they would be of their fellow direc-
tors or shareholders in a family owned company or even a public company.
The fact that a leaver who is subject to summary dismissal proceedings is often
dened as a Bad Leaver, with the resulting capped valuation of the individual’s
equity, means that there can be signicant amounts at stake over and above
the PILON payment or damages claim that would be lost by falling within the
summary dismissal circumstances.
A particular provision that investors and their advisers may look to include
in a private equity transaction is a clause enabling summary dismissal in the
event that a manager commits any breach of the investment agreement or art-
icles of association. Such clauses are often strongly resisted by management
teams and their lawyers on the basis that such breaches may arise inadvertently,
or may not be material, given the extensive nature of the consents, information
rights and so on in the investment documentation.
12
It is often argued that the
remedy of damages for a breach of those provisions is sufcient protection
for the investors, and that the signicant nancial impact that can ow from
a right to summarily dismiss is disproportionate to the wrongdoing attached
to such a breach. Nevertheless, such a right undoubtedly gives the constitu-
tional documents more legal teeth, and investors are often unsympathetic to
arguments that suggest a breach of the investment documentation may arise.
A common compromise is for such a clause to be worded in terms of material
or persistent breaches of the relevant documents, perhaps limiting the right to
breaches of specic obligations of importance, or carving out those matters
that are seen as less signicant.
12 See chapter 5 for more detail on the content of investment documents.
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Employment-related issues
2.6 Restrictive covenants
In addition to any restrictive covenants applying to the managers in the invest-
ment agreement (see chapter 5
13
), the investors are likely to want to see restric-
tions included in the service agreement in favour of Newco. The covenants take
various forms and may prohibit the manager from being engaged or employed
in or having an interest in a competing business, soliciting or dealing with cli-
ents or customers, soliciting or employing employees of the business or inter-
fering with suppliers.
It is beyond the scope of this book to set out a detailed analysis of the draft-
ing and enforceability of restrictive covenants; however, the general princi-
ples and background in chapter 5 provide helpful guidance for the purposes of
drafting or negotiating the covenants in the service agreement. The underlying
principle is that the covenants will only be enforced to the extent that they are
reasonable and necessary to protect the legitimate interests of the employer,
meaning that they must be limited in their scope and duration. As we have
seen, whilst the courts may be prepared to strike out those parts of the cov-
enants that are unreasonable, they will not generally be prepared to rewrite the
covenants. For example, if the period of restriction is unreasonable, the court
will not impose a shorter period, and instead the covenants will be unenforce-
able. For this reason, as highlighted already in chapter 5, it is common to offset
any period of garden leave against the period of the restrictive covenants; i.e.
the period of the restrictive covenant is more likely to appear reasonable (and
therefore enforceable) if credit is given for any period during which the man-
ager is excluded from the market whilst on garden leave.
In general terms, the covenants in the service agreement will usually be of
more limited scope than those in the investment documentation. It is usually
accepted that it is more reasonable for the investors, and possibly Newco, to
expect such protections in the context of their relationship with the individual
as a shareholder, than it is for Newco to seek such protection in the context of
an employee. As a consequence, whilst the language of the two documents
will usually be similar in dening what constitutes a competing business, or
a material customer, supplier or employee, the covenants in the service agree-
ment will often be of shorter duration.
2.7 Remuneration and benefits
The service agreement will set out details of the salary and other benets to
be received by the manager. These will often be discussed and agreed between
the managers and the investors directly, or with input from nancial advis-
ers, such that the lawyer is presented with a schedule of the benets to be
included in the draft contract. Details may also have been included in any
equity termsheet or questionnaire at the outset of the deal, to avoid difcult
13 See chapter 5, section 3.7.
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Employment terms
discussions at a later stage. In any event, the investors will wish to ensure that
full provision for all such benets has been included in the Business Plan, and
will use the due diligence exercise to verify the suitability of the remuneration
package, and a comparison of such proposed remuneration against that earned
by the directors concerned before the buyout.
One area where private equity investors can differ in their approach (both
when compared with other types of shareholder, and indeed amongst themselves)
is on the question of bonus schemes or payments for the senior directors. Often,
the management team from a buyout will be used to participating in a bonus
scheme under the previous ownership regime, and they may therefore expect such
participation to continue. However, investors will want to see managers move
away from a mindset of employment to one of ownership, and therefore may
challenge whether a bonus scheme is appropriate at historic levels, or indeed at
all. Depending on the particular circumstances, and the particular investor(s), it is
possible that a bonus scheme may be less generous to the senior directors going
forward, or be removed altogether, on the basis that managers will be substan-
tially rewarded for their performance through the life of the investment should a
successful exit be achieved. Managing the expectations of the investors and the
managers is key in this area, ideally by including full details of all remuneration
(including performance bonuses) in the Business Plan from the beginning.
Where a bonus scheme is agreed, the managers and their advisers may
wish to have the contractual comfort that comes from such arrangements being
clearly documented in the service agreement. At its most comprehensive, this
may involve agreeing complex denitions of prot-triggers and the setting of
year-on-year targets aligned with the Plan. However, given the unpredictabil-
ity of the performance of the investment, and how an unexpected outcome in
one particular year can render such incentives as redundant in that year and
future years, investors often prefer to leave the detail of any such arrangements
(including the setting of suitable targets) to the discretion of the remuneration
committee, on a more exible and ongoing basis.
The sensitivity of negotiations concerning remuneration and benets should
not be underestimated. Whilst managers will be expected to show some shift in
mindset from employee to shareholder, this cannot be expected overnight, and in
any event must be kept in check to ensure that a manager is remunerated fairly.
Sometimes, those benets that might be viewed as relatively insignicant in the
context of the deal as a whole, such as the make and model of company car or stand-
ard of business travel, can prove to be the most emotive issues for management.
2.8 Other terms
The service agreement will include other provisions typical for a senior direc-
tor. For completeness, these include:
(a) scope of role and duties, including job title, time commitment and work-
ing hours, and geographical location;
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Employment-related issues
(b) holiday entitlement;
(c) sickness absence provisions;
(d) provisions to protect condential information and company documents;
(e) express provisions to conrm that any inventions or other intellectual
property will be the property of the group; and
(f) disciplinary and grievance procedures and policies.
3 The interaction of service agreements and leaver provisions
3.1 General
An underlying premise in any buyout is that the managers have an ongoing and
integral role in the running of the business. However, the management team is
likely to evolve over time as managers depart (voluntarily or involuntarily) and
are replaced. Given that the purpose of equity participation for the managers
is to incentivise them, a departing manager will usually forfeit some or all of
his equity interest, and it will be redistributed to his replacement or amongst
the remaining managers.
As we have seen in chapter 5,
14
the articles of association will therefore
include ‘Good Leaver’ and ‘Bad Leaver’ provisions which set out the detail
of what happens to the equity interest of a manager who leaves the business.
It is worthwhile briey revisiting this issue, however, now that the content of
a service agreement is more fully understood, and the employment context in
which a dismissal takes place can therefore be appreciated.
Where a manager is a ‘Bad Leaver’, any shares held by the manager will be
compulsorily purchased, usually at a price which is the lower of the original
subscription price and the market price for the shares. There are a range of
approaches that can be adopted when drafting leaver provisions, but invariably
these will explicitly link the context in which the termination of employment
arises to the equity position of the manager on departure.
Where a manager voluntarily resigns, the position is fairly straightfor-
ward: he will almost certainly be treated as a ‘Bad Leaver’, unless there were
particular circumstances where an early resignation was envisaged (such as the
resignation of a founder manager after a handover period on a secondary buy-
out: see further chapter 12
15
). If the manager is dismissed, however, the position
is more complex and will depend on the circumstances of the dismissal. Often,
the investors’ preferred approach (or starting-point, at least) is to dene ‘Good
Leaver’ by reference to a limited number of dened categories (such as ter-
mination of employment due to death, normal retirement, ill-health and redun-
dancy) and to provide that all others are Bad unless a discretion is exercised
to treat them as Good. In those cases, and assuming the categories are drafted
14 See chapter 5, section 4.11.
15 See chapter 12, section 3.2.
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Interaction of service agreements and leaver provisions
fairly, this would mean that the manager will be a ‘Bad Leaver’ if, for example,
he is dismissed because he is seen as having generally underperformed.
However, where such an approach is resisted or negotiated, it may be neces-
sary to consider whether a manager has been unfairly dismissed or wrongfully
dismissed in order to ascertain how a leaver is to be treated. The question of
whether a manager can be summarily dismissed, or has been constructively
dismissed, may also be relevant.
3.2 Unfair dismissal
It is quite common to see the concept of unfair dismissal introduced when
negotiating the denitions of ‘Good Leaver’ and ‘Bad Leaver’. If such a con-
cept is accepted, the precise drafting will be key in determining what this
means in practice.
The right of an employee not to be unfairly dismissed is a statutory right.
In essence, in order for a dismissal to be fair, the employer must show that it
has a fair reason for dismissal (such as redundancy, conduct or capability) and
that it has followed a fair procedure. For example, if an employer dismisses
an employee due to redundancy, a fair procedure would require the employer
to show that it had fairly selected the employee for redundancy, consulted the
employee about the proposed redundancy (including considering alternative
employment opportunities in the group) before conrming the decision to dis-
miss, and then given the employee a right of appeal against the dismissal. For a
capability dismissal, unless the employee is grossly incompetent, a fair proce-
dure will usually require a series of warnings before any dismissal, with each
warning identifying the employee’s performance failings, setting objectives for
the employee to achieve over an identied timeframe, and making it clear that if
those objectives are not achieved a further warning (and ultimately a dismissal)
may follow.
It is therefore possible for an employer to have a fair and proper reason for
dismissing an employee, but for the dismissal to be unfair because the employer
has not followed a fair procedure. However, it is relatively common for employ-
ers not to follow a full and fair procedure when dismissing senior managers.
If the investors and/or fellow directors of a manager have lost condence in a
manager, the prospect of following a protracted performance management pro-
cess with a series of written warnings is unlikely to be attractive. The dismissal
is therefore often effected with little or no procedure being followed. Given that
the maximum compensation for unfair dismissal is capped (at approximately
£77,600
16
), this is often seen as a price worth paying to remove an executive
who is perceived not to be performing to the required standard. However, if
‘Good Leaver’ status follows from a dismissal that is procedurally unfair, the
16 This gure includes a compensatory award for loss of earnings of up to £66,200 and a basic
award based on length of service and age of up to £11,400, with such gures being revised
annually in February. This is the correct gure as at October 2009.
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Employment-related issues
equity implications of removing the manager without following a fair procedure
can be substantially greater than an employment claim for unfair dismissal. In
addition, the investors will be concerned that a relatively minor failure in a dis-
missal procedure may result in a nding of unfair dismissal.
In light of the above, the investors will want to ensure that procedural unfair-
ness in relation to a dismissal does not trigger ‘Good Leaver’ status. This can be
achieved by making it clear that only a substantively unfair dismissal, and not
procedural unfairness, will result in ‘Good Leaver’ status. The extensive set of cir-
cumstances in which a dismissal may be considered unfair, and a general assump-
tion that an employment tribunal may be more predisposed towards the employee
than an employer, means that some investors resist the concept in any event.
3.3 Wrongful dismissal
An employer wrongfully dismisses an employee if it terminates in breach of
the employment contract, i.e. it fails to give due notice without having grounds
for summary dismissal (such as gross misconduct) and, if applicable, fails to
make a payment under a contractual PILON clause.
In most cases, the fact that the employer has failed to give due notice will
not be seen as relevant to ‘Good Leaver’ status, and will instead be viewed as
a separate employment matter. An employee who is wrongfully dismissed is
entitled to bring a claim for damages reecting the loss he has suffered as a
result of the breach, i.e. a sum reecting salary and contractual benets for the
notice period but subject to the employee’s duty to mitigate his losses (i.e. take
reasonable steps to secure new employment and thereby reduce their loss of
earnings and the value of their damages claim).
As a result, the concept of wrongful dismissal is far clearer, and more under
the control of the investors and the other directors, than unfair dismissal. As a
consequence, the fact that an individual who is wrongfully dismissed will be
treated as a ‘Good Leaver’ may offer little meaningful comfort to a manager,
and on that basis might not be considered to be an appropriate test for deter-
mining whether a leaver should be treated as a ‘Good Leaver’ or ‘Bad Leaver’
at all. Nevertheless, it is not unusual for articles of association to include indi-
viduals who are wrongfully dismissed within the ‘Good Leaver’ denition.
This usually serves only to reassure the manager that his contractual position
will be adhered to, and does not in itself provide a manager with the protection
that there must be particular grounds supporting the decision for an individual
to be treated as a ‘Bad Leaver’.
3.4 Summary dismissal
17
An individual who is dismissed summarily will almost invariably be catego-
rised as a ‘Bad Leaver’. However, whether this is accepted as a given, or indeed
17 See further section 2.5 above.
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Interaction of service agreements and leaver provisions
might provide a basis on which the distinction between a ‘Good Leaver’ and
a ‘Bad Leaver’ might be determined, will depend upon how the grounds for
summary dismissal are dened in the service agreement.
For example, the service agreement may provide that the manager can be
summarily dismissed if:
(a) he refuses or fails to comply with any instruction of the board;
(b) he fails (in the opinion of the board) to perform his duties to a satisfac-
tory standard; or
(c) he commits any act which (in the opinion of the board) brings or could
bring himself or the employer into disrepute.
The above grounds are substantially broader than gross misconduct, and give
the board a discretion to determine whether the circumstances fall within the
relevant criteria. Whilst an employer must exercise such discretion in good
faith and must not act capriciously, the manager’s position is relatively weak
under the above drafting. Whilst a manager will not necessarily oppose link-
ing ‘Good Leaver’ and ‘Bad Leaver’ status to summary dismissal grounds,
management’s advisers should try to ensure that the grounds for summary
dismissal are dened as narrowly as possible.
Taking the three grounds referred to above, a manager’s adviser may begin
by looking to replace them with a simple reference to gross misconduct and
gross incompetence. However, if the investor refuses such a narrow approach,
a compromise may result so that, for example, summary dismissal only applies
if the individual:
(a) ‘Wilfully refuses to comply with any reasonable and lawful instruc-
tion of the board.’ This requires that the manager has wilfully refused to
comply with an instruction rather than simply failed to comply. It also
requires that the instruction is both reasonable and lawful.
(b) ‘Materially fails to perform their duties to a satisfactory standard pro-
vided the manager has rst been given written notice of such failure,
specifying the reasonable steps they must take to remedy such failure
within a reasonable period, and they have failed to do so.’ This requires a
material failure to perform and, by removing the reference to the board,
it means that the failure to perform must be assessed on an objective
basis. It also ensures that the employer must have notied the manager
of their failure to perform and given the manager the opportunity to
improve before summarily dismissing them.
(c) ‘Commits any act which brings them or the employer into disrepute
provided always that if such breach is capable of remedy, the manager
shall rst have been given written notice of the breach requiring them to
remedy the same within a reasonable period and shall have failed to do
so.’ In this example, we have again removed the reference to the board
so that whether the manager has brought him or herself or the employer
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Employment-related issues
into disrepute is objectively assessed. The wording also requires that
the manager has in fact brought him or herself or the employer into dis-
repute rather than simply requiring conduct that could bring them into
disrepute. Finally, the revised wording requires that the manager is given
the opportunity to remedy the breach in the event that it is capable of
remedy.
From this brief example, it can be seen that the merits of linking summary
dismissal to ‘Good Leaver’ and ‘Bad Leaver’ status depends on the detailed
drafting of those grounds. Such denition does not usually, in itself, provide
a satisfactory means for determining all the circumstances in which a dismis-
sal should result in an individual being treated as a ‘Bad Leaver’; however,
this illustration of the typical negotiation that can arise on a summary ter-
mination clause does serve to emphasise how the drafting of both the equity
and the employment documentation must be understood in detail for the full
commercial position to be appreciated. If an automatic ‘Bad Leaver’ status
is accepted in cases of summary termination, more expansive drafting in the
service agreement can result, as it will have far more signicant commercial
implications for the manager than was originally envisaged.
3.5 Constructive dismissal
Generally, if a manager voluntarily resigns from their employment, such
manager will be a ‘Bad Leaver’ and forfeit their equity. However, if the res-
ignation is in response to a fundamental breach of the employment contract
by the employer, the termination may, as a matter of law, be deemed to be a
constructive dismissal. Depending on how dismissals are treated under the
leaver provisions, this could therefore result in ‘Good Leaver’ status even if the
documentation is silent as to constructive dismissals. In any event, manage-
ment may look to negotiate that constructive dismissal is expressly treated as
a ‘Good Leaver’ situation.
If the concept of constructive dismissal is introduced in the articles, this
can be broadened or narrowed by expressly providing that a resignation for
‘good reason’ will trigger ‘Good Leaver’ status, and going on to dene ‘good
reason’, rather than relying on the common law test for constructive dismissal,
which requires that the employee resigns in response to a fundamental breach
by the employer. A range of approaches can then be adopted in relation to the
drafting of ‘good reason’. A narrow approach might be to conne ‘good rea-
son’ to a very limited set of circumstances, such as the manager’s removal as
a member of the board. A broader approach might be to add particular matters
to the common law test, for example specic assurances that have been given
to the employee, such as their reporting line and/or responsibilities.
In general terms, it is difcult for investors to argue that an individual
who is constructively dismissed should be treated simply as a resignation (and
therefore as a ‘Bad Leaver’), rather than as a dismissal (which may result in