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Beware of the elephant in the room!
Starting a company with other founders is like a marriage. At first it’s exciting, sparks are flying and you can only imagine good times ahead. BUT…beware of the elephant in the room! This article addresses how best to protect founders from that elephant. There’s no right or “standard” way for founders to do this since most situations are different based on the relationship of the founders.
As Noam Wasserman reminds us in The Founder’s Dilemmas “…it is much harder and costly to undo an early founding mistake than to make the right decision to begin with.” It’s important for founders to recognize and, if possible, address future problems that may arise as early on as possible. People are often called “co-founders” to sweeten the offer and it’s important to choose your co-founders with care (especially when they’re your friends!) In order to minimize these potential problems down the road, it’s often helpful for founders to clearly set out their respective roles, responsibilities and, possibly, performance targets in order to manage future expectations upfront.
In deciding who receives what slice of the equity pie, it’s a good idea to consider each founder’s past and future contributions, the opportunity cost and any valuable relationships that they may have. It’s better to ask what “value” a co-founder brings than what necessarily feels “right” or “fair.” Remember, the pie will hopefully have to feed many people (other employees, investors, etc.) and founders should be careful not to be too generous too early! As such, founders should keep in mind ‘dilution’ and be aware that giving away a fixed percentage of your company can be dangerous. On the other hand, opportunistically giving away slices of the pie may increase the size - or value - of the pie. A smaller piece of a bigger pie is always better than a bigger piece of nothing.
Since life doesn’t always work out as planned it’s important to remember vesting of stock among founders. Founders may fall-out, someone may move on, disappoint or underperform. Often viewed as imposed on founders by investors, vesting – the granting of ownership in stock over time according to a time and/or performance schedule - is a founder’s best protection against that elephant in the room. A typical vesting schedule may be something like a “four year, with one year cliff” - where 25% of stock only vests after one year and the remaining stock vests over following three years (say in equal monthly installments) so long as the founder is still employed with the company. When you’re imposing vesting conditions on stock remember to consider whether it’s advisable to make an election under section 83(b) of the tax code within 30 days of issuance of stock to avoid unexpected future deemed realizable taxable income. This election allows a founder to use the value of the stock when issued instead of when the stock vests so as to possibly avoid unnecessary future tax bills.
A few of the issues to consider when preparing a founders or shareholders agreement (or restricted stock purchase agreement) include: What should happen to a founder’s vested stock when she or he leaves the company? Should the founder continue to benefit in the economic upside of the company when no longer involved? At what price should the company repurchase founder vested stock and how should it be paid for? Does this change if the founder is fired for fraud or for some other significant failing? In what ways should a founder be restricted is her or his ability to transfer stock? What should happen if a founder dies or becomes permanently disabled?
Spending a few hours with an experienced business lawyer or other seasoned professional addressing these and other founder related issues can not only often increase the trust and confidence among founders, but also save you having egg on your face in the future if, and when, the elephant appears in the room.
This article is based on a talk presented as part of the Docracy/NYU-Poly Legal Stuff Explained Series on June 27, 2012. Nigel S. Austin, Esq. counsels start-ups and early stage companies and is the founder of Austin Law PLLC. He was formerly a partner at Proskauer Rose LLP representing venture capital and private equity investors and their portfolio companies with M&A transactions, equity and debt financings, licenses, joint ventures, employment contracts and equity compensation. . Special thanks to Sarah E. Coleman for assisting in the preparation of this article.
No communication by the author of this article is provided in the course of an attorney-client relationship and no such communication is intended to constitute legal advice. Nothing in this article should be used as a substitute for competent legal advice from a licensed attorney in your state.