It is vital to plan for a co-founder’s exit from the very start of the business relationship.
You are more likely to establish a start-up with a co-founder (or a few co-founders) than by yourself. Many entrepreneurs simply lack the appropriate industry knowledge and sometimes the human and financial resources to build a start-up on their own. Especially in the early stages, the value of the business is dependent on the input of key founders.
Assuming you have secured your perfect co-founders who fully complement the needs of your start-up, the next step would be to swiftly plan for the end – a founders’ exit.
Planning for a founders’ exit may be difficult, but be that as it may, it is imperative that you do so in the early stages , when there are fewer chances of hostility and push backs when negotiating a potential exit as everyone is rational and optimistic about the future. This contrasts with a later stage (when a founder is most likely to exit), especially when the exit is motivated by conflicts or a breakdown of the business relationship.
Very early on, it is crucial that co-founders document the essential terms that will govern their business relationship in a founder agreement. Among these terms, the founders must decide on the manner in which a founder can be bought out (for example, by way of a buy-back by the company, by the remaining founders or by a third party investor). It is also very important to agree upfront on the method of valuing the exiting founder’s equity – whether this will be by agreement, determined by the company’s auditors or determined by an independent valuer.
Apart from the founder agreement providing certainty on founders’ buy-outs, it is important that the interests of the company and other founders are protected by ensuring that a founder’s intended contributions (either in skills or financial resources) are provided before issuing them with equity in the start-up. You might be pushed to initiate a fellow founder’s exit when they suddenly become unengaged and are hanging around or simply accept equity without real ongoing contributions. After all, the purpose for which the business is established should always be greater than the individual founders. Our company law is very clear about the separation of legal personality between founders or shareholders and their company. As such, it is possible for a company to survive founders’ breakups, provided that the founders have carefully planned exit points that do not cripple their business post-exit.
One way to try guarantee the founders’ ongoing contributions to the company’s growth is to build in a vesting condition before issuing them with shares. For example, you can provide that each founder’s shares vest over a 4 year period, provided that such founder’s intended contributions to the company are made (in skills or capital). Then, if a founder exits before the end of his/her vesting period, the company can buy-back the exiting founder’s unvested shares at a nominal price notwithstanding the founder’s contribution up to his/her exit. Vested shares would normally be sold to either the company or the remaining founders by the exiting founder at a pre-determined market value.
Important provisions relating to a founder buy-out by a third party to be included in the founder agreement include “tag-along” and “come-along” clauses. A “tag along” (or “minority calls”) clause provides a minority founder with the protection that he/she can tag on to any potential exit by a majority founder. This provision protects the interests of the minority founders against being left behind when the majority founders exit the start-up, and also places them in a stronger negotiating position than they would ordinarily have been as a minority.
On the other hand, a “come along” (or “majority calls”) clause provides that if a majority founder wants to exit the start-up, he/she can force the minority founders to sell their shares on the same terms. This protects the majority, as a third party may not be interested in buying less than 100% of the start-up. The aforesaid terms can have major benefits for the purposes of expediating third party founder buy-outs.
If affordability permits, the company can also make contingency plans such as taking out a key person insurance policy for the business. This policy can assist in a key founder’s exit and ensure the ongoing profitability and sustainability of a business. It is intended to provide the company with cash flow to enable the business to continue operations while a suitable replacement is sought.
Lastly, it is important that the founders approve some basic non-compete terms for purposes of protecting the start-up’s proprietary interests and trade secrets once the founder has successfully been bought out, namely:
− Restraint of trade: As a business founder, one of your many concerns is to ensure that that your proprietary interests are protected. This is especially a concern where it comes to founders who have access to very important proprietary interests, including, trade secrets / confidential information of the business, details of and relationships with customers and suppliers, and who can use such access and information to damage your business;
– Non-solicitation: This clause is typically built into the employment agreements between the company (employer) and the employee (founder / director-founder). The purpose is to ensure that the former founder (who might also be an employee), is prevented, during his employment and thereafter from wooing existing or future employees and clients of the start-up;
– Intellectual Property (IP): This is especially important in circumstances where the start-up’s value is anchored in the IP of the business and where the founder is also involved in developing or advancing such IP. The clause can simply state that all the IP belongs to the company and that any founder / employee or third party involved in developing the IP shall do so for the benefit of the company and not for personal gain; and
– Confidentiality: Lastly, a general confidentiality clause must be built into the agreement to restrict the founder from disclosing trade secrets or any other valuable information of the company to rival companies or using such information for personal gain.
In conclusion, the importance of agreeing on and documenting exit and the related anti-compete terms at an early stage of the start-up company cannot be under-estimated. This is solely the founders’ responsibility.
Prince Mathibela is a Candidate Attorney at Dommisse Attorneys as part of the Transactional Team enhancing his skills in corporate finance, merges and acquisitions and corporate restructuring. Visit: www.domisseattorneys.co.za