“Founders should have a history before they start a company – otherwise, they are just rolling the dice.”
– Peter Thiel
Choosing a founder is like choosing a marriage partner –
yes, it is that important.
Initial Founder Considerations
The initial founders’ agreement is like a prenuptial agreement, and makes people just as uncomfortable. Who wants to think of breaking up the minute you have decided to get together?
There are a number of start up programmes that seek to match a commercial person with the technical founder. This may sound like an easy way to find a suitable co-founder – but in this game, nothing is easy. For a founding team to have the best odds of success, they need to get to know each other well on a personal, social, and professional basis. As they say in life: marry in haste, repent at leisure.
In too many cases, the first time a formal founders’ agreement is entered into is when an external investor requires it. This can be too late — there are plenty of horror stories involving founding teams who have split acrimoniously before any investment has been sought.
A simple example of something to be avoided would be where a founder leaves a business at a relatively early stage and holds onto all of their shares, while the remaining founder(s) then continue the tough journey to grow the business. Most people would believe that it is unfair that the departing founder maintains their full shareholding in these circumstances, but that’s exactly what will happen if there is no founder agreement to the contrary. An even worse example would be if that former founder holds on to their shares and subsequently seeks to block a certain corporate action — like an exit / acquisition.
In addition to drafting a formal written founders’ agreement, it is vital to ensure that everyone agrees on:
- the vision of the business, which may change over time, but still needs to be shared by the founders; and
- the direction in which they want to bring the company.
Even when founders agree about the company’s growth trajectory, consider also what happens if that growth trajectory does not come to pass, or takes far longer than anyone anticipated.
A highly-recommended book dealing with these types of tough choices is “The Founder’s Dilemmas“ by Noam Wasserman. Peter Thiel has also written extensively on these challenges in his recent book, “Zero to One.”
The following elements should be discussed from the outset:
- the roles that each founder is likely to take, and whether those positions are likely to be replaced by more experienced personnel as the company grows; if that occurs, what happens to the replaced founder?
- whether one or more of the founders are willing to relocate if required by the business; this is particularly important for the CEO if the company’s main customer base is outside of your home country
- what constitutes “success” for the business? Would one founder be happy building a ~$50M business whereas the other wants to “swing for the fences” and build a $200M+ business?
- is there an agreed exit scenario, or indeed, any exit scenario at all?
- how much should founders get paid? Should all founders be paid equally? What happens if some founders grow into more senior positions and others don’t?
While the above can be discussed/agreed outside of a formal written agreement, there are elements that should be put in writing.
Answers to the following should be agreed in writing:
- are the founders required to contribute initial cash to the business; if so, how much and in what proportion? One founder may have cash but the other may not, and the non-cash-contributing founder may be the first to commit to the company full-time.
- what is the initial division of shares between founders?
- how are shares dealt with if a founder leaves or is unable to contribute fully to the business? Usually, founders will agree to a “reverse vesting” schedule, whereby departed founders will “lose” a certain percentage of their shares depending on how long they stayed. This should be discussed and agreed at the very beginning, it is the biggest cause of upset and disagreements later.
- reverse-vesting requires a good deal of thought – it’s arguable that any founder who leaves before the closing of a seed round should lose the vast majority, if not all, of their shares
- another model to consider: in addition to a percentage of the founder’s shares being forfeited if they leave, remaining shares can continue to be forfeit depending on the length of time between their departure and an exit of the company. The theory here is that, if a founder leaves and the company is sold within 6 months, it is more likely that the founder will have contributed to that value than if an exit occurs 5 years after the founder’s departure — after the remaining founders and senior employees have built up the lion’s share of that value.
- how are serious disagreements between founders dealt with?
- what matters will require unanimous or majority founder consent, e.g. funding, share allotments, hiring etc.?
- what happens if a founder is not performing at the required level?
- what happens to a founder’s shares in the unfortunate event that they die or become permanently disabled?
- it might be hard to agree that your shares should not be inherited by family, but it is equally hard for the other founder(s) to agree to what could be a completely unqualified individual having involvement with the company.
- in these circumstances, something like a Power of Attorney in favour of the remaining founder could be considered, whereby the family of the deceased founder retains economic interest in the company, but has no voting/other rights of control or rights to a position on the board.
Practical Note on Share Repurchase
In Ireland, the mechanics of reverse-vesting of shares is quite tricky. Under normal circumstances, shares cannot simply “disappear” and either need to be transferred to someone else, redeemed by the company (when they can be cancelled), bought back by the company or another nominated person, or converted to a new class of share.
- If the shares have any objective value greater than their par or nominal value, then a transfer of those shares for less than market value will result in a taxable gain for the both the person who transfers the shares as well as the person to whom the shares are transferred.
- There are strict conditions to be met by a company that wishes to redeem or buy back its own shares; these conditions are, in practice, difficult to meet by non-profitable startups.
- Forfeited shares can to be converted into e.g. a non-voting share with no economic rights. This requires a new class of share to be created and the process for conversion needs to be outlined in the company’s Constitution.
- The ability to buy-back shares for e.g. par value, can continue to apply indefinitely and, if there is an exit, either a co-founder can exercise their right to buy the shares at the time (which will still lead to a taxable event) or the acquiring company could purchase the shares for nominal value. Beware however that, if you have to rely on your “drag along” provisions to complete an exit, normally those terms require that shareholders can only be “dragged” if they are offered the same amount for their shares as other holders of the same class; if a departed founder is only to receive par value for their shares but other ordinary shareholders are to receive more, that can cause problems operating the drag provisions.
- There’s a strong argument for putting in a buy-back provision (e.g. at par), having it last indefinitely and just dealing with it at a point in time when you have the money or real motivation (in the form of an exit) to exercise the buy-back rights. We recommend keeping your options very broad to include any of the possible scenarios, such as a buy-back (in favour of anyone the board directs), a conversion into any new class of share, an agreement to enter into a power of attorney in respect of the shares, the entering into a nominee agreement, the transfer of the beneficial interest in the shares, mandating that the departed founder grants options over his/her shares e.g. to employees etc. etc. so that, even though you don’t execute any transfer at the time a founder leaves, you give the company broad discretion to ensure that the spirit of the original agreement can be implemented.