There’s a saying in the start-up world, ‘Choose your co-founder wisely, for founder exits can be messier than celebrity divorces!’
Err, actually, there no such saying – we made that up! But it’s not far from the truth. Founder exits can be messy, stressful, painful, and confusing for everyone involved – the exiting founder, the continuing founders, the investors, the employees, and the business partners. But they need not be – if companies are adequately prepared for such an eventuality, the transition can be made relatively smoothly and with as little damage as possible.
Founder exits happen for many reasons, from misalignment between co-founders to the exiting founder wanting to move on to something else. With the stakes being as high as they are – a poorly managed founder exit can even lead to the company failing – it’s important to understand what arrangements, in legal and practical terms, need to be in place. In this blog, we focus on what kinds of agreements can be put in place.
Impact of exit on stakeholders
A company is seeded from an idea and is built on the collective skillset of a team of founders. They lay a foundation for not only a company’s business but also its culture. This culture in turn shapes the company’s employees and its growth in the long run. With one of the founders looking to exit, a question naturally arises in the minds of employees as to what happens next. Further, even short-term instability in company management, particularly when founders are involved in management, can lead to demotivated employees and a drop in productivity.
Investors don’t escape this speculation and uncertainty either. Especially during the initial rounds of financing, an investor’s decision to invest depends a great deal on what they perceive as the founders’ potential. An impending exit of one of the founders creates doubts in the minds of the investors, which may even lead to the company struggling to raise more funds.
Ideally, what protections/arrangements need to be in place?
It’s never wrong to be prepared from the very beginning. Signing a founders’ agreement is the first step. The exit clause in a founders’ agreement prepares everyone for the eventuality of a founder exit. It captures how the founders’ shares vest and what procedures the founders and the company must follow when any founder exits the company voluntarily or otherwise (termination due to misconduct, negligence, etc.)
Amongst company and founders
The articles of association govern the internal affairs of the company, they supersede both the shareholders’ agreement and founders’ agreement.
Since founders are the main participants in the initial team and are mostly (although not always) on the board of directors (‘Board’), the articles will typically contain a clause covering founders’ exit. The exact terms may differ from company to company, but the articles will state how an exit by one or more founders must be treated. This includes clarity on who continues on the Board and who’s in charge of leadership and decision-making. While specific procedures may change from company to company, in terms of compliance, the following practices are common.
- If a founder director wishes to exit the company, and also resign from the Board, then the exiting founder/director must file form DIR – 11 with the Registrar of Companies (ROC) along with a copy of the resignation. This must be followed by the company filing Form DIR – 12, stating change in directorship.
- If a founder has committed misconduct, fraud, abandonment of responsibilities, or otherwise breached his employment or consulting agreement with the company, the company may terminate their services of. The termination paperwork, where such a founder is also a director, will involve the Board passing a resolution and the filing mentioned above being completed.
Amongst investors, company, and founders
Founders often wear many hats. Since founders are also shareholders in the company, they are bound by shareholders’ agreements. Important terms that find place in these agreements are vesting; right of first offer (ROFO) and right of first refusal (ROFR); non-solicitation and non-competition; and protection of intellectual property (IP).
- Founders holding substantial shares post their exit can be detrimental to a company and its stakeholders. Their shareholding comes with rights to cast votes and potentially control management decisions. An ex-founder with this power could create roadblocks for the company. Besides, it may also cause resentment amongst continuing founders that someone on the side lines is receiving benefits out of others’ work without contributing. Hence, an arrangement where each founder’s shares are vested over a certain period of time ensures that when any founder leaves, they do not walk away with more than what is fairly and equitably due to them.
- Vesting terms may differ, based on whether the founder’s departure is voluntary or involuntary. Typically, terms unvested shares of the founders are –added to the unvested shares in the stock option pool or transferred to the continuing founders of the company.
Non-solicitation and non-competition
Founders must agree to non-competition and non-solicitation clauses while signing employment or consulting contracts with the company. Their main objective is to protect the company’s business, goodwill, and reputation. Every founder commits that they will not directly or indirectly: (a) involve themselves in any activity that could create competition to the company’s business, (b) persuade the company’s other stakeholders to stop working with the company, or (c) hire any current employees of the company – as long as they are working with the company and for a specified period post their exit.
ROFO and ROFR
Founders’ shares may also be subjected to ROFO and ROFR. These terms ensure that the founders’ shares are transferred first to the existing shareholders of the company before being offered to any other third party. Typically, investors insist that no founders’ shares can be transferred without their approval.
Protection of IP
An important factor to consider is the IP or proprietary information that is crucial to running the business. There must never be any doubt about who owns the IP. Companies are built on ideas and hence it is essential that the manifestation of these ideas are registered in the name of the company. Imagine a founder exits with the IP in his or her name. The company will not be able to carry on business unless the IP is transferred to the company’s name. And if the founder is not cooperative, it will lead to legal battles that can run into years with the company taking the hit. Hence, it is best that the ownership of the IP is clearly defined in the employment/consulting agreements signed by the founders right from the beginning.
As can be seen, a founder’s exit must be accomplished smoothly. A private limited company need not wind down operations just because a founder exits. To avoid founders locking horns – with each other or the company – down the line, it’s best to be prepared from the start with adequate processes in place.