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Co-Founders: Hash Out Your Rights Early!

When you start a company on your own, life can get pretty difficult, and you alone are responsible for building, operating and growing your venture. One positive aspect of being a solo entrepreneur is that all decision-making is in your hands – you don’t need to build a consensus of one.

On the flip side, having a group of co-founders allows for shared responsibilities, with the group allocating tasks to the most suitable person. Having multiple founders certainly eases the burdens of facing the whirlwind of activities required to build a business. But co-founders are often so caught up with tackling the day-to-day challenges of a startup that they pay little attention to hashing out their legal rights.

Very frequently, companies with multiple co-founders will form a legal entity, determine each co-founder’s stake in the company, and then postpone consideration to any other of their respective rights. And why not? Startups are often cash-strapped, and the general line of thinking is: “We’ll wait on further legal work (and legal bills) until we raise a round of funding or need to negotiate a major contract.” Yet, ignoring the interplay between the founders can lead to some uncomfortable situations.

Co-founders should consider how to handle situations in a few basic categories:

Ownership. Consider restricted equity, which is subject to vesting over time. This way, while each founder has skin in the game, none can simply pick up their shares and go home. Too often, one co-founder drops out of the venture in the early stages (whether due to business disagreements or personal issues), but because the equity wasn’t structured to vest over time, the departing founder walks away with his or her full stake in the company. Don’t forget to ask your legal and accounting advisors about an “83(b) election.”

Further, reflect on options regarding the transfer of equity. Should there be restrictions on a founder transferring shares to an outsider? Should the other founders or the company have rights of first refusal to purchase the shares of a departing founder? Should the other founders have co-sale rights, allowing them to “tag along” in sales by one founder to a third party? Answering these questions ahead of time can prevent major disagreements if and when the dynamics among co-founders begin to change.

Control. Multiple founders beget multiple voices and opinions, and decision-making can become difficult without a sense of which voices will carry weight. Should all co-founders sit on the Board of Directors, or just one or two of the group? Board decisions are typically made by majority vote, but give thought to whether major actions should require a supermajority of the founders, or even a unanimous vote. Examples of such major actions include acquisitions, the sale of the company, issuing equity, incurring debt and key hires. Understanding how key decisions are made, and who has a say in these choices, is vital to avoid the possibility of a tug-of-war over the strategy and direction of a startup.

Exit Strategy. “Drag-along” rights can be extremely important, and yet usually are not considered by co-founders at the outset. These rights will force a minority stakeholder to go along when a critical mass of founders has determined to sell the company. This prevents a scenario where, for instance, four out of five founders wish to sell, yet the fifth founder, holding only 20% of the company’s shares, refuses to sell his or her stake. Participation rights also protect founders, giving each founder the ability to maintain his or her percentage of the company by buying in when the company issues additional equity.

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From a legal perspective, forming an entity should not be the one and only step for the founders of a startup. Taking the time at the beginning to sit down and hammer out a clear understanding of these types of issues is critical. If we’re dealing with a corporation, these rights should be spelled out in a separate stockholders’ agreement. If the startup is a limited liability company, these provisions can be added to the LLC’s operating agreement.

Co-founders wouldn’t launch a new business without clear, delineated ideas about their product or service, their market, and the problems they wish to solve. To minimize internal strife or disputes that can disrupt these business goals, they should approach their corporate structure at the outset with the same level of clarity and vision.

 

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