Problems often develop in an emerging growth company when a co-founder receives a minority equity stake that wasn’t earned over time, wasn’t subject to vesting and/or wasn’t paid for, and he or she does not become an employee or contribute actively to the company’s growth trajectory. He or she may stray from the mission of the company for any number of reasons, including unforeseen changes in life circumstances, priorities or personal preference. This is a common issue for start-ups, and multiple problems may arise from the situation, which include the following:
First, as time passes, if some co-founders contribute and others don’t in a manner that is commensurate with the amount of equity owned, resentments ultimately and logically develop among the company’s management group.
Second, in companies raising venture capital from investors who want to reduce the amount of “passive equity” in the company’s capitalization table, i.e., minority equity stakes owned by individuals not actively working for the company, the existence of a co-founder’s passive equity stake simply creates the prospect of conflict between the goals of an important prospective investor and the straying co-founder.
Third, the existence of a straying co-founder’s equity stake makes it harder to reward important employees with equity or options (or profits interests in a limited liability company) without further diluting other co-founders and equity holders who are active in management of the company.
Note that these issues exist whether the company is a corporation or an LLC. Holders of shares or membership interests are referred to as “equity holders” who hold “shares.”
So, how does a company prevent this situation? Some suggestions for company founders and advisers are as follows:
When forming the company, try to ensure that all co-founders’ shares (that are not paid for in cash) are subject to vesting over time, usually four years more or less—and try to tie vesting of shares to maintaining employment with the company, or at least a significant independent contractor relationship. Beware of situations where one of the co-founders does not commit to being an employee and does not intend to subject his or her shares to vesting, unless the size of the equity position granted is relatively very small and is granted for a clear, compelling reason.
In addition to tying vesting of co-founders’ share ownership to employment, upon a co-founder leaving or being terminated from employment with the company, the company should have the ability to repurchase such co-founder’s unvested shares at cost (virtually nothing), while leaving the vested shares in the hands of the resigning or terminated co-founder. In that case, a right of first refusal should be given to the company and the other co-founders to purchase the vested shares first, if the straying co-founder receives an offer to purchase from a third party.
A more hard-nosed approach sometimes involves documentation stating that: (i) if a co-founder who is an employee is terminated without cause (as defined), his vested and unvested shares may be purchased by the company and then the equity holders, and the vested shares will be purchased for fair value supported by an appraisal of the value of such shares; and (ii) if the co founder/employee is terminated for cause (as defined), the vested shares may be purchased at cost or some pre-agreed percentage of fair value. If the co-founder/employee leaves the company, this approach admittedly denies the founder the full benefits of equity investment (i.e., unlimited upside), even if his or her shares have vested. For that reason, this approach should only be considered in special situations. There may be circumstances, however, where all co-founders would like to impose these requirements on each other—or third-party investors may require it as a condition of investing. In any event, the only way the approach can work is if all co-founders and the company can agree.
So, a company can reduce the likelihood of experiencing the problem of a straying co-founder by requiring, at company formation, such co-founders to subject their shares to a vesting schedule when the company is formed, and tie such vesting to continued employment. What can be done if a straying non-employee co-founder owns shares granted outright with no vesting schedule, and for which he or she did not pay? The answer is, not much, if the goal is to free-up equity to grant to contributing employees without diluting the active co-founders’ pre-existing equity stakes. All the company can do is try to negotiate with the co-founder, or simply issue more shares, options or profits interests as the case may be.
The negotiation often takes the shape of an attempted buyout, initially pursuant to what is in a shareholders agreement, or in the case of an LLC, an operating agreement. Such agreements spell out the circumstances under which the company has the right to purchase a holder’s shares. One instance usually occurs when a third party makes an offer to purchase a holder’s shares and the company is granted a right of first refusal, followed by a similar grant to the equity holders. Sometimes, such agreements will also provide for the company’s right to purchase at fair market value upon death or divorce of an equity holder. But such agreements do not usually provide that a co-founder’s shares will be forfeited simply because he or she is not active or helpful in management, nor do they allow the company to repurchase an individual equity holder’s shares for any reason. Once a co-founder owns shares, however passive or uninvolved he or she might be, he or she owns them, and practically, the only way to dislodge those shares for the purpose of freeing up equity for deserving employees is to negotiate creatively.
It is important, however, for the company and its other equity holders to understand the potential downside of attempts to negotiate with a co-founder (or any minority equity holder) in this situation. The company may try to create incentives for the straying co-founder to re-vest, relinquish or sell his or her equity. In the process of doing so, however, the company also needs to avoid pressing so hard that it may be accused, under relevant state laws, of minority shareholder oppression, breach of fiduciary duty of the majority to the minority, or failure to deal in good faith. These are topics for another discussion.