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It’s a tale as old as time — or at least as old as modern corporate legislation, case law, and regulations permitting. A team of founders taking on the world with the next big idea. The Three Musketeers: brilliant, infallible, loyal, and optimistic.
The “All for One and One for All” attitude permeates through the early organizational framework of the start-up, and more importantly through the ownership structure of the corporation. Maybe that’s your situation, three friends going into business together, equally contributing and pulling their own weight.
It’s only fair that everyone gets a perfectly equal split of the outstanding shares in the corporation… right?
In this blog post, we will be examining founder scenarios that our clients and lawyers have seen over the years, how an innocent seeming circumstance can turn into a major problem, and strategies you can implement into your own start-up to mitigate that risk.
When a company is started, assuming that responsibilities are relatively equal, and depending on the size of the initial founding team, the shares are split with individuals receiving between 10% – 50% of the total amount. By design, these shareholders have considerable voting power in determining which direction the company is going; shareholders, directors, and officers of a start-up are usually one in the same.
Where the Problem Comes Up
As your company inevitably increases in size and investors and other players are thrown in the mix, disagreements as to how to run the company may come up. Furthermore, not all founders remain in their original roles long-term, so smooth transitions in and out of the company should be prioritized from the start.
Equally apportioning shares across a founding team may also have negative impacts external to the company as well. With corporate growth also comes the inevitable milestone of raising outside capital. Big-time investors are professionals who are in the business of financing start-ups, and they will perform thorough due diligence to ensure that a company will turn out to be a good investment. One of the factors examined is the equity distribution amongst the founding team.
Prospective investors will be wary that founders in an even distribution did not take the time to ask difficult, yet critical questions about allocations of responsibilities and time, instead favouring an easier equal split.
This signals to investors that the founding team may be hesitant to confront awkward conversations or deal with challenging business decisions. If you’ve read some of our content before, this is a textbook case of pushing aside legal problems until they come back ten-fold to cause bigger headaches down the road.
We’ll keep saying it: tackle your problems early and decisively.
Take Example Co.
The founding team split their shares 40:30:30. One day, Example Co. realizes it needs external financing so they go out and canvas some angel investors. The investors give our founders the terms of the deal, but one shareholder isn’t happy with it.
The two shareholders who held 30% each voted to move forward with the financing round which (like all equity investments) involved a certain percentage share dilution to the investing party. The 40% shareholder was extremely unhappy with the terms; they believed they would be able to expand with far fewer resources, and thus less share dilution.
Although the investment was beneficial for the company, the 40% shareholder decides to leave the business while still holding their shares. In the absence of any kind of legal agreement preventing this behaviour, almost half the value of Example Co. is on the outside because of a typical business disagreement. Even if the 40% shareholder decided not to leave, voting on matters that require a certain percentage of the outstanding shares could render company decisions grinding to a halt because of the concentrated power held by a single party.
Corporate action that may significantly impact the future of the company generally require supermajority votes, which can be anywhere from 66% – 90% of the total shares required. Having dominant abstaining parties, whether from an egoistic thought process or poor planning can lead to painfully slow or even absent decision-making (often called hold-up risks).
Founderproofing is the simple idea that a company’s frontrunners will protect the business from any possible conflicts, unexpected departures, or mistakes made by the founding team themselves. This is generally done through binding legal documents like shareholders and founders agreements.
It may be a new concept to many, and perhaps this problem wasn’t even on your radar. Discussing how to resolve conflicts within a close-knit group of founders is probably one of the last things a new team of entrepreneurs wants to think about. However, for the sake of repeating ourselves, like with all legal issues, pushing problems aside until they become too big to ignore will cause more issues than if they were properly addressed from the start.
You might be thinking that we’re exaggerating or that the above Example Co. scenario is over-the-top. Maybe you can’t imagine a world in which the founder team you’re a part of would ever jeopardize the business you’ve all worked so hard to build. You might get along great with your co-founders, and you’ve been through thick and thin together. We’ve seen it all before — sooner or later, human nature gets in the way and these so-called hold-up risks happen in every new venture. No business is immune to having to make difficult decisions.
So what’s the best way to founderproof?
Three times in one post! You’ve heard from us over and over again – start early and plan ahead! Having clauses in your Shareholders Agreement encouraging positive behaviour and restricting negative ones go a long way in figuring out what to do when you run into these situations. Being able to point to a binding legal document is a surefire way to import certainty into tough scenarios.
Apportion Different Equity Amounts
An extension of starting early (is that four times then?), one of the biggest mistakes that founder teams make is splitting shares equally among each founder. It makes sense in principal; everyone in the venture together, no one being “worth” more than the other, etc.
In practice however, the wise business decision is to sit down with your co-founders and outline each person’s roles and responsibilities. Very quickly, it will become evident that some founders will be devoting more of their time into the business, or some founders will have the necessary skills to materialize whatever idea you went into business with (i.e. they’re indispensable). Having apportioned equity properly will mitigate hold-up risks and allow smoother transitions into different organizational players if the need arises.
Avoid High-Risk High-Reward Compensation Structures
Whatever agreements your company has in place should encourage predictable and rational behaviour. High-risk high-reward structures usually take the form of performance incentives. Often, these incentives are structured so large portions of shares vest at a single time in lieu of a high monetary salary. While the vesting period – the time that has to pass for the shares to go to the individual – may vary, the important factor to consider is if the shares will vest all at once, or periodically.
Let’s say a bunch of stock will vest if a director makes it the two-year mark of satisfactory corporate performance. They’re three months away from getting to cash in their shares, but they’ve made a big mistake that could severely harm the company’s long-term future health. In pursuit of their own self-interest, that director will do everything in their power to make sure they hit that three month milestone, often to the company’s detriment.
The better business decision will be for the director to own up to their mistake and get help from the rest of the company to limit the negative effects. If the director is self-serving however, they’ll actively work to cover the mistake up, limiting the amount of time they can dedicate to other company matters and placing the business in a worse position than if they were to come clean.
This behaviour happens more than one realizes and planning from the start can help to mitigate it.
Set up a Formal, Effective Board of Directors
The astute reader will have come across two common themes in this post: start early and founders are human beings.
As human beings, founders have the tendency to become very fickle and emotional – particularly when dealing with the company they helped create. Having an impartial, effective Board of Directors takes away many of the risk factors and triggers that could lead to founder issues. As the Board of Directors sets the direction of the company, founders can spend their time developing the great idea they wanted to create in the first place, while leaving the business and logistical element to experienced and neutral third parties. That’s not to say that the founder(s) will lose their entire voice in company operations, boards can be set up in a variety of ways in which equitable distribution of responsibility can be achieved.
How can a lawyer help?
If you want to get ahead of this problem early, we recommend chatting with a lawyer. You will be able to get advice that's tailor-made to the nuances of your company and specific situation.
If you’re looking to get a Shareholders Agreement for your company, check out this link for more information.
Read more about Starting a Business topics that may be helpful to you and your small business.