This article was prepared by Jeremy Halpern and William J. Bernat, members of the Emerging Companies Group at Nutter McClennen & Fish LLP.
Conventional wisdom is that startups with cofounders succeed more often than startups run by solo entrepreneurs. Whether true or not, startups with multiple founders face key issues that will affect the company and its ability to raise money, grow, and ultimately be successful. By tackling the issues early, with candor and honesty, cofounders can often prevent damaging personal relationships with one another and can position the company for growth. In addition, the ability to make these hard calls is a good signal to investors and employees about the sophistication and maturity of the entrepreneurs.
Allocation; Control and Governance
The biggest question often faced by startups is allocating the equity among the founders. There is a tendency, mostly arising from a sense of “fairness,” to divide the equity equally, often with disastrous consequences. In situations where a company’s equity is held equally among the founders and they no longer agree on direction, the lack of a tie-breaking vote is often fatal to the company’s ability to make decisions and move forward. It is rare that the cofounders shoulder the same responsibilities, work the same hours, contribute the same intellectual property, or take on the same reputational risks. As a result, it is common that cofounders find such an arrangement unfair over time. More sophisticated entrepreneurs allocate the equity after a thoughtful consideration of the completed and expected contributions of intellectual property, cash and services.
That said, there are many situations, such as mergers, liquidations, management changes or other key decisions, in which founders want the ability to block such transaction without a super majority of votes. This is the balance between the ability to move forward, and the danger of one majority cofounder acting as a tyrant. When setting these super majority thresholds, founders should be mindful that, as the company grows and their ownership percentages in the company are diluted by future equity issuances, their relative voting power will also be affected.
It might be intuitive that founders would own their equity out- right, without restrictions. But as it turns out, this often leads to unwanted consequences. More sophisticated founders understand that there is huge value in subjecting founder equity to vesting, wherein each founder needs to earn all or a portion of his or her shares through the performance of management services. If a founder fails to perform such services, typically by leaving the company, his or her equity is subject to repurchase by the company for a nominal amount. This prioritizes and values “execution” over “ideas” in the ultimate allocation of equity, and incentivizes the founders to remain engaged.
By way of example, if, shortly after cofounding the company, Founder A quits, it would seem unfair that the remaining cofounders would have to do the work and take the risks that might enrich Founder A. Additionally, the company is likely to need to hire a replacement for Founder A’s services, and such candidate is likely to demand a substantial equity stake to perform such services. In the absence of the ability to repurchase Founder A’s shares, the issuance of equity to Founder A’s replacement would dilute both the value and the percentage ownership of the other cofounders.
In order to protect the founders from losing their investment due to an involuntary termination by a capricious board, provisions can be included to ensure that the company’s repurchase right does not apply to situations where the founder was terminated by the company without cause or voluntarily terminated his own employment for certain specified reasons.
Founders should be aware that subjecting their shares to vesting has potentially significant tax consequences and that, in most cases, they should make a filing with the IRS under Section 83(b) of the Internal Revenue Code after consulting with their attorney.
Restrictions on Transfer
Except for restrictions imposed by securities laws, a founder is typically free to transfer his or her shares at will. That prospect, however, does not usually sit well with the other founders, as it leads to the possibility that voting and economic rights could be transferred into the hands of a third party with whom the other founders have no existing relationship or worse still, a competitor. For these reasons, it is pretty typical for founders to agree to certain upfront restrictions on the transferability of their shares. Such restrictions can take several forms, including an outright prohibition on transfers without the consent of a certain percentage of the other stockholders, or a “right of first refusal” in favor of the company or the other stockholders.
Under a right of first refusal, before a founder can transfer his or her shares to a third party, he or she first must offer them to the company and/or the other stockholders at the price at which the third party has agreed to pay for them. The right of first refusal provides some protection, but to the extent that the company or the other stockholders don’t have the available cash to purchase the applicable shares, the transferring founder would then be free to transfer his or her shares. An accompanying right that you often see alongside the right of first refusal is a co-sale right. Although more common in an angel or venture-capital lead financing, the co-sale right is an agreement between the founders that, if any one of them finds a purchaser for his or her equity, the other founders will be able to participate in such sale by including a portion of their shares on a pro rata basis.
When coupled together, the two provide the non-selling founders with a bit of an upside, as they’d be able to exercise the right of first refusal if they think that the price offered by the third party is too low, with a chance to exercise their co-sale rights if they think the third party price is too high. Certain exceptions are typically made for transfers made to family members or estate planning vehicles if the transfers are being made for bona-fide estate planning purposes.
Founders should expect, however, that in most cases their shares will be completely illiquid until a sale or IPO of the company.
Death/Disability of Founders
Although not pleasant to think about when forming a company, founders should consider the proper course of action in the event that one of them dies or becomes completely disabled. Absent any contractual provisions to the contrary, a deceased stockholder’s shares would pass to his or her estate. The surviving founders may want to prevent the deceased stockholder’s shares from ending up in the hands of his or her heirs, especially if the deceased stockholder owned a large percentage. It’s not untypical for founders to agree that the company and/or the surviving stockholders have the option to repurchase the deceased stockholder’s shares from the estate at the then-fair market value or some other agreed-upon price. In many cases, this buyback is funded by “key man” life insurance policies maintained by the company on the lives of their founders. Investors also often demand such policies because it is another way to ensure the company has resources to prevent dilution upon having to hire replacement senior management.
Intellectual Property and Restrictive Obligations
It is important in forming a company for all of the participants to fully contribute the intellectual property related to the business to the company. Through an “assignment of inventions” each founder should be required to assign to the company any intellectual property related to the business, whether developed before or after formation of the company. When combined with obligations of non-disclosure, non-competition and non-solicitation, a company can best protect the commercial value of the innovations being developed. Each founder should be motivated to ensure than any person leaving the company’s employ cannot take with them the valuable intellectual property which they have collectively generated. Where cofounders wear multiple hats, or have multiple ventures, it is important to determine exactly what is and is not being contributed to the company.
While founders might be in agreement on how things should be resolved on day one of their company’s existence, their points of view might change drastically at any point along the path, often clouded by self interest. This makes it all the more important to think through these issues early and address them upfront in a founders’ agreement. While there is no universal answer as to the “right” way to solve these complex issues, it is almost always true that it is faster, better and cheaper to deal with the hard questions early rather than wait until a time the cofounders have clearly opposite priorities.
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