Not all great companies are the product of great founding teams, but few companies can survive a dysfunctional founding team for very long. That is why it is critically important to find co-founders with whom you can work effectively and who complement your skills and mitigate your weaknesses. Much of this comes down to personality, work ethic and other intangibles that can only be truly tested and proved when you are in the trenches together building a company. This leads to the obvious question of how founders can protect themselves and their companies if the person they thought was the peanut butter to their jelly turns out to be anything but. The answer is creating a solid legal framework that (a) establishes clear expectations for the roles and responsibilities of each founder, (b) provides a mechanism for resolving disputes, and (c) sets out a framework that will allow co-founders to part ways while without destroying the company.
Establishing clear expectations for the roles and responsibilities of each founder requires an open and honest conversation about the value each founder brings to the table and how that value should be compensated. These conversations usually reveal some differences in how each founder views their value and the value of other founders. Recognizing these differences early, when founders are still in the honeymoon stage of their relationship, allows the founders – usually with the help of counsel – to come up with creative ways of bridging the gaps between each founder’s expectations.
One effective mechanism for doing this is by subjecting a portion of each founder’s equity in the company to “vesting” based on the achievement of certain personal or company performance targets. The performance targets should be thoughtfully established based on the differences in expectations among the founders, as should the amount of the founder’s equity that vests upon achievement of the performance target. It is particularly important that either achievement of the performance targets be easy to ascertain or a clear process for determining achievement be established so there is unlikely to be any disagreement over whether the target was achieved.
While using performance-based vesting can be a very effective way to help founders establish clear expectations of their roles and responsibilities, because every founder in a startup is expected to wear many hats, it is best that most vesting be tied purely to time served to discourage any founder from focusing on achieving performance targets to the detriment of the company’s overall business needs.
The appropriate mechanism for resolving disputes among founders often depends on the relative power of each founder over company decisions. If there is one principal founder who will own a majority of the equity in the company and have the final word on all decisions, a dispute resolution mechanism may be unnecessary. But where there are circumstances in which a disagreement among the founders could prevent the company from functioning, it is helpful to have a means of breaking the deadlock.
The most common method is by providing for a process by which, after allowing some time for the founders to reach a compromise, each founder has the right to buy out the other founder(s) or require the other founder(s) to buy them out. There are a number of variations on this type of “buy-sell” mechanism, but the result is always one founder being bought out by another.
Regardless of the specific process, it is important that both the means for determining the purchase price and the terms of payment should be clearly established. Often a third party is brought in to value the company if the founders are unable to agree, and the company typically insists on payment over 2-5 years in order to spread out the considerable expense of repurchasing shares from a founder.
To prevent the departure of a founder from sinking a company, particularly where the departure is not under good circumstances, founders should establish a clear framework for what will occur in various circumstances. There are at least four scenarios the founders should consider: (1) the company or the other founders decide to terminate the employment of a founder because the founder has done something materially detrimental to the company (what is generally referred to as “cause” for termination); (2) the company or the other founders decide to terminate the employment of a founder without “cause”; (3) a founder leaves voluntarily, which may include a founder’s death; or (4) a founder leaves because the company has deliberately taken action to make their employment more difficult (what is generally referred to as “good reason” for leaving). In the case of scenarios 1 and 2, a key question the founders should address at the outset is whether the company’s decision to terminate a founder’s employment requires approval of one or more of the other founders.
For all four scenarios, the founders must decide how much of the departing founder’s ownership in the company they get to keep. Typically, a founder gets to keep all their “vested” equity and the company has the right to repurchase the unvested equity for a de minimis price, but if the founder is terminated for cause the company often gets the right to repurchase all of the founder’s equity and if the founder is terminated without cause or the founder leaves for good reason, some or all of the founder’s unvested equity might immediately vest and therefore not be subject to repurchase.
Whether you are starting a company with your best friend or a few people you met at a coffee house, you can’t predict how the relationship among founders will change over time. Many companies (and friendships) have been ruined because a difficult situation arose and the founders could not agree on how to resolve it. To prevent disputes among founders from destroying your company, founders should work with the company’s counsel to establish a legal framework that spells out what the founders’ rights and obligations are towards each other in certain circumstances.