Issues for the Start-Up

Far too often the founders of a start-up company neglect the issues that can later become contentious if the enterprise does not succeed as everyone hopes and expects.  Indeed, it not uncommon for one or more of the founders to eventually become unhappy and either seek a way out of the venture, on his or her terms of course, or look for ways to take over the company.   This lack of “contingency planning” is not due to carelessness.  It is simply human nature.  Founders who are excited about their future prospects and confident in the strength of their friendship and mutual respect see no reason to address the remote possibility of irreconcilable differences in the years ahead.   However, there are some issues that should be addressed early precisely because the founders are then in a cooperative and collegial frame of mind.  If left for the future, any serious disagreement about the direction of the company, or the allocation of accumulated enterprise value, will make it hard, if not impossible, to reach a common ground because the status quo will favor one party or the other in the dispute.

Here are some issues to include in agreements of the founders at the outset (or at a later stage if not addressed at the time of formation, assuming the founders are still on good terms):

Assign all IP to the Company

Many start-ups begin with an idea or ideas that are unique and innovative.  These ideas are or can become trade secrets, and may even be patentable.  In either case, they have value.  Sometimes one founder has the original concept and others either enhance the concept or bring something else to the venture, such as funding or skills in engineering, marketing, finance, or management.  Typically, the company is formed after the ideas have evolved to the point where their potential commercial value makes it worthwhile to pursue the cost of forming a legal entity and launching a business.  But what happens if one of the founders later decides to leave or is forced out, particularly if he or she was an “inventor” of the company’s proprietary ideas?  Can this former founder use the same or similar intellectual property to start a competing company?  If the question were to be asked when the company is formed, the founders would almost certainly agree that the answer should be “no”.  However, if the question is not asked until the founder leaves the company, it becomes a legal question, probably a complex question, and more likely than not the answer would not please the remaining equity holders in the company.  Hence, the founders should all assign to the company any rights they may have to any IP used by the company and they should sign a non-disclosure agreement with respect to any trade secrets or other IP owned or used by the company.  This non-disclosure agreement should be written so that the obligations survive the individual’s relationship with the company.

Equity Allocation

If there was ever a source of resentment and ill will, this is it.  Founders often start with the egalitarian notion that all founders are equal.  However, success frequently reveals that some founders made and are making a greater contribution to that success than others. For example, the person who conceived the core concept and who has enhanced it through development may be more valuable to the company that a person who brought capital or marketing skills.  Why, the first person will wonder, should both individuals always be treated equally?  The second person will, of course, say that that was the deal.  Maybe so, but more than one company has broken up because the “deal” eventually proved unsatisfactory to a key founder.

This poses a difficult dilemma because most individuals tend to over-value their contribution to a common enterprise and under-value the contributions of others relative to their own.  Hence, it is almost impossible, and certainly awkward, to periodically allocate profits or equity based on relative contributions.  An alternative is to allocate restricted shares to the founders at the outset but assign different forfeiture schedules, depending on each individual’s expected contribution.  For example, each of four founders might be granted 10,000 shares, all with full voting rights and participation in any dividends, but the shares held by the person who conceived and develops the company IP might be subject to a more favorable forfeiture schedule.  Say, if that person leaves the company within four years he or she might forfeit the number of restricted shares determined by multiplying 2,500 times the number equal to the difference between four and the number of full years employed, whereas the others might forfeit the number of restricted shares determined by multiplying 1,250 times the number equal to the difference between eight and the number of full years employed.  If an individual who leaves the company can sell back to the company at fair market value the shares no longer subject to forfeiture, there is an added benefit in the forfeiture schedule granted to the founder who conceived the technology.  This arrangement reflects the fact that an innovative IP contribution is likely to have greater relative value to the company than other contributions in the early years, although everyone will eventually come out equal if they all stay with the company until the restricted shares are longer subject to forfeiture.  Not coincidentally, this also gives the other equity owners an incentive keep the IP developer happy during the period when the technology is having the greatest impact on earnings.

A separate issue related to forfeiture schedules is the question of who gets the “accretion”.  In the example above, most founders assume that if one founder leaves and forfeits some of his or her restricted shares, the forfeiture of restricted shares by the departing founder will increase the value of their shares, and only their shares, by a pro rata commensurate amount. However, if there have been subsequent stock issuances since the restricted shares were originally issued, such as the issuance of shares to management or sold as part of a fund raising effort, all shareholders will see an increase in the per-share value of their shares as a result of the forfeiture.  This outcome, which often comes as a surprise to the remaining founders, can be addressed in a restricted stock plan but it usually is not.

 Buy-Sell Agreements

This is the area where the absence of an agreement can eventually lead to much angst, if not bitter, protracted disputes.  The question is easy to ask but hard to answer:  What happens if the founders reach a point where they cannot or do not want to work together, however remote that may seem at the outset of their common venture?  If there is no written agreement to answer this question, the parties will more likely than not find it extremely difficult to reach a resolution through negotiations.   The agreement most commonly used to address this issue is the Buy-Sell Agreement.  There are two types of Buy-Sell Agreements: traditional and “guts ball”.  In a traditional agreement, each party to the agreement has the right to sell his or her shares, but subject to a right of first refusal held by the company or, if the company does not exercise the right, held by the other shareholders who are parties to the agreement.  In addition, if any event occurs that could cause a party’s shares to be sold or transferred at a price that is not the result of a negotiated price between a willing buyer and a willing seller, such as a bankruptcy or divorce, the company can buy the shares at fair market value, as determined by an independent appraiser appointed by the company.

In a “guts ball” agreement, which is most commonly used in cases where there are two shareholders but can be used with more than two, either of the parties to the agreement can, at any time, offer to buy all the shares of the other party at a stated price.  Once such an offer if made, the party receiving the offer has two choices and only two choices:  either sell at the stated price or buy the offering party’s shares at the same per-share price.  If no decision is made within a specified time, usually 30 days or less, the party receiving the offer will be deemed to have elected to sell his or her shares.  These “guts ball” agreements may seem awkward at an early stage of a company when the founders cannot foresee the day when they might radically disagree on something, but in fact such an agreement can forestall future disagreements because both parties know what might happen if a disagreement turns ugly.

Other Common Provisions in a Shareholder Agreement

There are other issues to be considered for a formal agreement among the founders, and these should not be left for the day when venture capitalists arrive on the scene to dictate the terms of their participation in the company.  For example, when there are more that two initial shareholders, what happens if there is an opportunity to sell the company at an attractive price and the shareholders disagree on the question of whether to proceed with the sale?   This might be easy to answer if the number of shareholders is small and all are equal because decision-making in such a situation usually requires unanimity.  The question becomes more difficult as the number of shareholders or the disparity in voting power increases.  What if there are five shareholders and only four want to sell?  What if there are three 30% shareholders and one 10% shareholder and the latter does not want to sell?   One common solution is a combination of “drag along” and “tag along” rights.  Under the “drag along” rights, if the majority, or some higher required percentage, wants to sell but a minority shareholder does not, the minority shareholder can be “dragged along” and forced to include his shares in the sale at the same price per share as the others.  Conversely, the “tag along” right protects the minority shareholder in the situation where a buyer wants to minimize the purchase price buy acquiring just a majority of the shares and then perhaps reorganizing the acquired company and eventually squeezing out the remaining minority shareholders with a cash out merger.   The “tag along” provision allows, but does not require, each minority shareholder who is a party to the agreement to sell his or her shares in any sale approved by the majority on the same terms and at the same price per share as the majority.

The issues above are merely some points to explore with an experienced attorney and do not constitute legal advice.    Every start-up is different and every situation must be considered in light of all the relevant circumstances, particularly the objectives and interests of the founders.

Corporate Law Advisers, LLP

An affiliate of The Corporation Secretary

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