The Five Rules of a Start-Up Company Prenup
When small teams of two or three start a company, optimism generally reigns. After all, you’ve got a really great product idea, you really know the target market, and at least one of you really knows how to sell. Plus, all of you worked together before at a successful large company. I mean – what could possibly go wrong? The answer is: Plenty and then some. Here’s the not quite inclusive list:
- One of your co-founders doesn’t quite possess the skills you expected. For example, your CEO is actually bad at sales, or your CTO can’t get a product out the door.
- After a couple of years, one of you decides that there’s a better opportunity lurking inside another company or decides to go on a one-year walkabout in Australia.
- One of you develops a substance abuse problem.
- As the Company expands, new hires assume work previously performed by a co-founder. The co-founder objects - loudly.
- The actions of some combination of investors, customers, and new employees cause the company to pivot away from its original plan, and a co-founder resists.
The purpose of this post is to give you advice on how to avoid “future trouble.” We’ll describe the things that could go wrong between co-founders and provide you with advice on how to avoid those things before they happen – or at least have a mechanism for dealing with them. The bottom line is this: As co-founders, you have to plan for the worst from the day you start your company. You need a start-up company prenup.
Here are our five must-haves in a start-up company prenup:
1. Vest your stock over a long period of time.
A lot of co-founders want to vest their stock at inception. This is a bad idea, because, if things don’t work out 12 months out, remaining management and investors are stuck with a lot of dead shares on the cap table. This makes it harder to raise funds and offer shares to new hires, who will carry on the work of a departed co-founder. We recommend a vesting period of at least four years. If your co-founders are all pulling their weight, you want to encourage them to stay. If a co-founder wants to leave early, you want to get their unvested shares back to use to recruit a replacement. With time to IPO now taking longer (at an average of 11 years for 2014 tech IPOs), some investors argue that four-year vesting isn’t long enough.
2. Determine in advance when and how a founder can be removed.
In most cases, at least two co-founders have board seats and often control the board – even when outside investors have put money into the company. In that circumstance, a co-founder can only be removed with the consent of the other co-founder. You need to define in writing how and when a co-founder can be removed. Typical causes for removal include:
- Failure to meet assigned goals.
- Failure to embrace the business plan of the company.
- Poor management of subordinates.
3. Make the break as clean as possible. Departing co-founders should leave the Board of Directors as well.
There are well documented instances where a departed co-founder continues to provide value to a company – either by providing valuable advice on operations or technology or by providing connections that help grow a business. Most of the time, however, this doesn’t happen. It’s important that a departed co-founder never “rule from afar.” We recommend that you make sure that management board seats are tied to continuing employment in the company. After all, it’s likely that the co-founder left for one of two reasons: (1) a disagreement over performance or the direction of the company or (2) a desire to do something different. Either way, the departing co-founder isn’t likely to be committed to your new way of doing things.
4. You need to restrict the transfer of stock on private markets.
There’s been a big business in the last few years in selling employee shares on the secondary market. Our advice is that you implement a blanket transfer restriction on employee stock sales without some form of company consent. Usually, this means board-level consent. This restriction is especially important, because you can’t simply change the rules for founding shareholders at a later date. It requires the consent of the shareholder, and you’re unlikely to get it since the right of resale is valuable. The right of resale is particularly important for co-founders, who frequently possess a high percentage of the available shares. You should also consider this as you mull over whether to restrict share resale: Co-founder shares can create competition if you are out raising funds to grow your business. And, when the co-founder sells shares, the business doesn’t gain an influx of new funds – only new, unknown shareholders.
5. Avoid accelerated vesting upon departure or an M&A transaction.
Vesting of founder shares is tied to continued employment in the company. What happens if the co-founder leaves? Should the shares continue to vest? Should vesting be accelerated? The correct answers are “no” and “no.” Assuming that you’ve agreed upfront on the method for removing a co-founder, the remaining co-founder is better off returning that equity to the pool to incent the employees who will carry the business forward.
In the event of an acquisition, there are two possible scenarios:
- A single trigger acceleration vests all founder shares when an acquisition closes. This is sub-optimal, because the acquirer usually wants to retain the management team for a period of time. Most of the time, to complete a transaction, the acquirer will insist that management either give up single trigger vesting entirely or keep some part of the payout in escrow in exchange for continued service after the acquisition.
- A double-trigger acceleration fully accelerates vesting only if the acquirer decides not to retain a founder after an acquisition closes.
The Bonus Rule
In closing, let me offer one more bonus rule:
When you start your new thing, retain a really good lawyer, who understands your market and knows how to structure your company, so that you can avoid toil and trouble down the road. In short, your lawyer should have deep experience with the “five rules.”
If this seems like an unnecessary expense out the gate, consider the much higher cost and personal pain of fixing co-founder-related problems later. If you’re still not convinced – well, I’ve enlisted the FRAM oil filter man and his friend, the mechanic, to re-enforce the message. Their wise words (with accompanying video) are: