A Pre-Nup for Start-Ups?

08 September 2010 Publication
Author(s): Gabor Garai

Legal News Alert: Private Equity & Venture Capital

The early days of a start-up company are always filled with hope, excitement, and trust. It is not a time when most entrepreneurs think things won’t work out, much less that they may not work out well. Business partnerships, like marriages though, sometimes end in disappointment. Not acknowledging this possibility in the early days, when everyone is getting along, can lead to disastrous results. It's far better to anticipate possible issues in advance and create a structure for resolving them in a constructive manner then addressing the issues for the first time when anger is already clouding judgment. Here are some suggestions.

Make Sure That All IP Is Assigned to the Company

Quite often there are ideas, trade secrets, and even patentable inventions that are developed during the earliest stages of a business, as founders brainstorm about markets, applications, processes, etc. The legal entity is generally formed later. All founders — and anyone else involved in the venture, be it informal consultants, advisors, and even girlfriends and boyfriends who had access to IP — should sign an assignment and nondisclosure agreement. Just remember, if anyone can prove that an invention was not properly protected as a trade secret — as in being freely discussed with friends and advisors — it can invalidate the company’s ownership rights.

Develop a Thoughtful Equity Allocation Plan

Not all founders are equal. Each brings different values to the table. If one founder is perceived as getting more equity than he deserves, the resentment will fester and, ultimately, undermine the relationship. Look at long-term needs and capabilities and apportion equity based on aggregate expected contributions.

Tie Stock Ownership to Meaningful Milestones

Some founders — such as the inventor of the fundamental technology — bring significant value to the venture at its very conception. Others bring capabilities — such as finance and marketing — that might be more relevant in the next phase of the company’s growth. Issue stock to all founders, but subject them to restriction (vesting) based on the timing of the value creation expected by each founder. Then, if someone leaves the venture before she contributes the expected value, her shares would be forfeited — and available to her replacement, who will need to produce the specific value that her predecessor did not deliver. For example, issue 30,000 shares each to the inventor and to the finance person, but provide that the inventor forfeits 15,000 shares if she leaves within one year, whereas the finance person forfeits 25,000 shares. Both founders must continue to build value after receiving their shares, but more of that value may be "on the come" for the financial founder than the inventor.

Incorporate Reasonable Two-Way Termination Clauses in a Stockholder Agreement

Both the company and the founders need to be protected against unexpected events: personal and financial circumstances that require a founder to move on; disappointing performance; lack of compatibility among founders; or demands by angels or VCs that a heavy hitter be substituted for one of the original members of the management team. Proper safeguards, including both fair descriptions of various termination events and fair procedures to determine consequences, not only minimize conflict when someone departs, but also set a constructive atmosphere for the enterprise.

Remember the Impact of Dilution

If one founder leaves after a series of additional shares were issued to management, angels, and even VCs, the percentage of equity that his forfeited shares represent is effectively redistributed to all other stockholders. This might come as a surprise to the remaining founders, who may have expected the return of the forfeited shares all to themselves. There are solutions to this problem, though they're somewhat awkward. Of course, keep in mind that any shares (or options) subsequently issued to the person replacing the departed founder would also dilute all of the other shareholders' equity in the company.

Don't Reinvent the Wheel

All of these issues have been addressed and solved many times over. While no agreement is perfect, a well written set of documents reflects the accumulation of many years' worth of experiences and balances simplicity (and cost) against covering each and every contingency, however remote. Create a roadmap that's clear and accurate, but avoid specifying every possible side street or detour.

No one expects a romance — whether in personal or business life — to end in conflict, though some do. And no one should create conflict by obsessing about the "what-ifs" of a possible breakup. Thoughtful planning enhances and strengthens the relationship and avoids many of the pitfalls of a possible split-up.

Content first appeared in the MassChallenge blog (June 2010).

Legal News Alert is part of our ongoing commitment to providing up-to-the-minute information about pressing concerns or industry issues affecting our clients and colleagues.

If you have any questions about this alert or would like to discuss the topic further, please contact your Foley attorney or the following individual:

Gabor Garai
Boston, Massachusetts