People start businesses together hoping for the best. At the outset, every relationship includes excitement, wonder, and potential. After some time, though, reality sets in and the underbellies of vulnerability and uncertainty are exposed. As you learn and grow together, co-founders don’t always see eye to eye. It’s important to anticipate some challenges and be prepared to deal with them fairly.
Any time you join forces, the energy and chemistry can either work well together, or blow up. I’m sure we’ve all experienced different dynamics and frustrations from group projects in our schooldays. Now imagine some of those same issues – freeloading or coasting, domineering or controlling – with your livelihood on the line.
In this Dispute Resolution series, we’ll explore some common scenarios to highlight strengths and weaknesses of different sides and show (hypothetically) how valuable it can be to have a neutral perspective when partners reach an impasse.
Equity: Percentages and Power
Ownership is one of the core aims of an entrepreneur. When you slice it, though, the percentages can represent more than math to some. Whether it’s ego or economics, people put a lot of weight in their ownership interests and care deeply about the fairness of how the company is divvyd up. There are a few different approaches to dividing equity that can help address those group project problems I mentioned – freeloading or coasting, domineering or controlling. Vesting and voting.
With vesting, we often see a four-year period with a one-year cliff, but you can decide on the checkpoints that make sense for you and your business. In some circumstances it may not be logical to vest ownership solely on time. In those situations, milestones can be thresholds like a revenue target, number of customers or sales, or other markers or earnings.
Founders usually get their chunks upfront, so they own their shares on day one, subject to repurchase with reverse vesting that allows the company to buy back unvested shares at a nominal price. After the vesting period is complete (or all the milestones are fulfilled), the shares are all theirs without that risk or asterisk. Early employees, on the other hand, normally receive stock options, which give the recipient the ability to purchase shares at a set price as they vest. If at any point along the way, a founder or option holder loses interest or wants out, they can take what’s vested by keeping shares or exercising options to buy them before that window of opportunity closes, but they leave the rest/unvested ownership behind.
Voting is the other thing that comes into play with these fractions and figures. The most common approach is one vote per share, 1:1, or pro rata based on percentage ownership, with majority rules. There are plenty other approaches, though, that range from dual-class structures with one non-voting, or 2:1, 3:1, 5:1, or 10:1 tilts, to supermajority hurdles like 60% or 75%. Founders sometimes have the misconception that owning a hair over 50% is the key to maintaining control, but that’s not always the case and you can plan ahead for different scenarios. Dilution can be a growing pain: https://fourscorelaw.com/how-does-dilution-work/
Let’s look at an example with three founders, and one that isn’t carrying her weight. It’s the eve of the first anniversary of forming the business, and they all have the standard one-year cliff for vesting and majority rules for voting. They all agreed to equal 1/3 ownership at first, but the other two grew frustrated and now want their outsized contributions valued. Should they band together to fire the third on day 364 so they can move forward together as 50/50 owners? If they do, does the cliff really mean the third gets nothing for her work?
Faced with this dilemma, reasonable minds differ. You could approach this scenario with a deep decisive paper cut: based on the documents, the third owner wouldn’t be entitled to anything. A clean break like that isn’t necessarily less messy, though. The ousted owner may be hurt by such a sudden move, and choose to compete or complain. Since startups tend to play fast and loose with more buttoned up business practices like labor law and minimum wage requirements as they bootstrap, claims like these may be viable and ultimately cost more than sharing a piece of the pie. This hypo is an example of how important it is to properly document things like intellectual property assignment, non-competition covenants, confidentiality terms, and those sorts of things upfront and head-on day 1 because if an issue like this arises later, the departing owner could turn that leverage into a ransom of sorts.
You could try to split the difference and wait until the anniversary to cut the third so they get some vested ownership and have what amounts to a mere token of appreciation, or a treasure. When founders leave after some shares vest, the company or remaining owners usually negotiate a buyout so future owners or investors don’t wonder or worry about who that is or what happened. Whether they vest or not, some thinking and consideration outside of the four corners of the contracts can help everyone land on footing without adding insult to injury.
A few takeaways: don’t wait until a deadline to make drastic and devastating decisions like these. Take time. Weigh options and avoid unpleasant surprises. If you’re taking equity compensation that was expected away, it’s worth considering or offering some other recompense for any work performed. For example, there could be an invoice for services rendered before the departure and rational calculations of value and fairness to pin down a dollar amount. At the end of the day, you may want just two founders left standing, but how you get there matters.
- Have conversations before conflicts arise. Think through whatever you can think of. Anticipating pain points and getting ahead of them can help take the sting out of conflicts. For instance, a buy-sell provision is something co-founders can pin down so the process of parting ways is laid out. Here are a couple articles about the importance of reaching buy-sell agreements at the outset: https://fourscorelaw.com/how-do-buy-sell-agreements-work/ https://fourscorelaw.com/buy-sell-agreements-in-partnerships/
- Clarify confusion. Chances are, if you think something is not entirely clear/certain, it isn’t. Even your understanding may be a misunderstanding, so always ask questions if you have them. Whether the answer reinforces your interpretation or widens the divide, you’re better off knowing and taking it from there.
- Get to the root of the issue. Sometimes, as professionals especially, we have a tendency to let things build up to a point where we forget what the original sin was. Don’t always give grace or save face if something bothers you. Nip certain things in the bud and hash them out so what you have moving forward is compatible and sustainable.
- Do unto others. This is a key to compassion: imagine you are in the position of the person that’s on the chopping block, then consider what would make you feel respected. Then do that. We can’t let dollars and endeavors become so focal that we forget humanity, humility, kindness, and decency. Every business is a people business.
The next topics in this Dispute Resolution will be Decisions: Respect and Recognition, Workload: Titles and Time, Intellectual Property: License or Leave It. This isn’t so much legal counsel as it is psychology in the context of business law. There are all sorts of factors that can swing things one way or the other. The idea here is to help you think through approaches to problems, including when not to approach things without an outsider to help people distill what matters.
Headquartered in the Research Triangle region of North Carolina, Fourscore Business Law serves entrepreneurs and businesses in the Triangle, throughout the Southeast and in Silicon Valley / San Francisco. We also represent venture capital funds and other investors who invest in companies throughout the U.S. The idea of delivering maximum impact in a simple and succinct manner is what we’re calling the Fourscore Principle. And that is what Fourscore Business Law is based on. Our clients operate in a broad range of industries including tech, IoT, consumer products, B2B services and more. Questions? Shoot us an email or give us a call at (919) 307-5356. Your first call is on us.