It’s extremely unfortunate, but the sad reality is that startups often close down when founders experience a falling out. The founders are rightfully considered the beating heart, the steering wheel, the essence and spirit of the early-stage company, and any dispute or quarrel can be devastating to the company and its technology, and consequently result in substantial loss for existing investors and have a deterrent effect on potential investors.
Even though we see these situations often, only few entrepreneurs truly understand the importance of addressing the possibility and implications of separation in the founders’ agreement, and how beneficial it can be to set forth in advance specific mechanisms to address certain aspects of founders’ feud.
When founders, who are the pillars of the company, especially at the early stages, trade cooperation for bickering, it is almost inevitable that operations will come to a halt, business will become paralyzed, and existing and potential investors will grow despaired and discouraged. Under such circumstances the value loss will be considerable, and chances of recovery grim.
When I step into such a situation, my goals are to offer tools and solutions that will enable the company to continue operations seamlessly, to mitigate loss of value, and when possible – help the parties separate on amicable terms.
It is however no secret that having proper mechanisms in place for resolving disagreements and settling disputes between founders can dramatically improve the company’s chances to survive such a crisis, especially if it’s an early stage company, keep value loss to a minimum, and help the departing founder move-on with little or no discontent.
The mechanisms I’m referring to must be simple to understand and easy to implement, and I strongly recommend including them in the founders’ agreement from the outset, for dealing with some of the most common issues that arise when founders are at ends.
It can be argued which of these issues is considered a “poison pill”, but it goes without saying they can all have a material adverse affect on the company, technology, and the ability to carry-on its business. Naturally, not all of these aspects and solutions are relevant for every venture and company, but I strongly recommend considering them when attending to the separation mechanisms in the founders’ agreement:
(1) Who continues with the Company? How do you answer the question who gets to continue with the company and who waves farewell? This is especially tricky in 50-50 ventures, but nonetheless complicated when one founder has more equity than the other.
(2) Ownership Allocation: Reverse vesting is a mechanism commonly used by founders for circumstances in which a founder hasn’t fulfilled his/her duties, and that his/her replacement requires substantial equity compensation. A lot has been said about the disadvantages and taxation exposures in this mechanism, but the reverse vesting mechanism is still commonly used. For further reading on Reverse Vesting read this post by my partner Ran Dimant.
Voting as a director– to the extent that the founder had rights to appoint a director (alone or with others) – these rights should expire, as it’s very problematic if a departing founder keeps such an ability to steer or otherwise influence the company.
Voting as a Shareholder – a departing founder will most likely continue to hold shares in the company. However, the remaining founders and the investors would most likely prefer to avoid having to deal with the departing founder every time there’s a shareholders meeting and so on. There’s also a question as to whether it makes sense that a departing founder will have a “say” about a venture that he/she left. We recommend securing, when signing the founders’ agreement, a signed proxy for voting the shares of the departing founder at the general meeting and even for other consents that might be required from the founder as a shareholder.
(4) Legal quorum: sometimes founders’ agreements will include a quorum clause, whereby the general meeting cannot assemble without the presence of each of the founders. Obviously this situation is extremely problematic when there’s no cooperation between the founders, because it means that the shareholders meeting cannot convene if not all founders cooperate. I strongly recommend avoiding such a requirement.
(5) Veto rights: a departing founder cannot have veto rights in the company. Once a founder becomes non-engaged in the company any veto rights previously granted must expire immediately and automatically.
(6) Incurring obligations and further investments: if the founders are financing the operations of the company, what happens when a founder departs but continues to hold equity in the venture? Is the founder obligated to participate in further investments? Is he/she entitled to repayment of any shareholder loans?
(7) Defamation: defamation can cause enormous damage, both to the company and to the departing founder. We recommend that the separation provisions will include a non-defamation provision, whereby both the company and the departing founder will be prohibited from defaming the other or the company’s business or affairs.
(8) Title: will the departing founder continue to hold the Founder title? Will he/she still appear in the company’s website with this title? How will this issue effect investors? Will the departing founder continue to be bound by limitations with respect to his shares, such as no-sale?
(9) Non-competition and non-solicitation: the departing founder must be prohibited from establishing or otherwise being involved in a competing business. He must also be prohibited from enticing employees, advisors, suppliers, partners or customers away from the company.
These are but some of the issues that I deal with when founders need to separate. Having a few simple clauses in the founders’ agreement dealing with the implications of separation can save a lot of effort, time and money down the road, but even more important – might be the reason for which the company could continue operations and not dissolve.
Einat Katzenell is the Founding Partner of Katzenell Dimant and provides strategic and practical legal advice to hi-tech, life sciences and biotechnology entrepreneurs, investors, early stage and mature companies, academic institutions and business initiatives.
DISCLAIMER: Blog posts are not designed to provide legal advice or create a lawyer-client relationship. You should not take action based on this content.