Get Your Pre-Nup

Start-Ups: Get Your Pre-nup

Two or more people decide to launch a new business, and this is how it typically goes down regarding the relationship between them: "We have known each other for a long time, or our interests are totally aligned and we see it through together through the exit, or what can possibly go wrong, let’s not think about worst case — so a handshake must surely be enough." Yeah, right. Until it isn’t.

Not to rain on anyone’s parade, but in my experience in most cases the original team that enthusiastically embarked on the venture was disbanded, in some cases shortly after the start, and sometimes right before the company was trying to take it to the next level. That’s a really bad situation. And that’s why I insist that all my clients formalize the relationship between the company’s founders from the start.

Think of it as a pre-nup. Hopefully you will not need it. If you do, the process will be painful—but at least you will have set the ground rules for the separation.

From the get-go, the partners should put it in writing each founder’s role and responsibilities, including:

  • Time commitments
  • Titles
  • Expectations as to where the company is heading, and
  • The respective roles in the day-to-day operations of the business.

I have seen too many startups make the mistake of assuming that every decision has to be made collectively, and that every founder should have an even measure of control over every decision. Time and again, that creates confusion and frustration which can be avoided by reaching a consensus at the start.

The agreement would also cover ownership percentages of each founder (you would usually have 80-90% fully diluted equity available to distribute because 10-20% is typically allocated to the option pool). This is obviously vital and may be sensitive in many cases because it is not necessarily a given that everybody’s piece of the pie is the same size. If you agree on it upfront, you’ll avoid disappointment/arguments later. In that context, make sure you implement a vesting schedule, which future investors will eventually want to see in any case. The customary vesting period is four years, with a cliff after one year and then monthly installments.

The agreement should also address how key decisions will be made (for example, capital raises and the sale of the business), and how to resolve a deadlock.

Another area of importance is to agree on how to handle a partner’s exit from the business and the entire array of issues surrounding that:

  • Should the company, or the other founders, have a right to repurchase the stock?
  • Will the vesting continue even after a founder’s departure?
  • Will the partner continue to have the right to vote on matters/stay on the board?
  • Should there be non-compete or non-solicitation provisions to protect the franchise?

Other areas to think about include whether there should be drag-along rights to make sure no founder can block the sale of the business or create a hold-out situation, and tried-and-true transfer restrictions that make sure that the company does not wake up with strange bedfellows—or (everyone’s worst nightmare) a competitor as co-shareholder.

I could write a book about shareholder agreements, which I may actually do. After all it’s my favorite topic. But you don’t have to make it too complicated, just do something! Cover at least the basics. Then you don’t have to worry about it anymore and can work together to create the success story that you started your venture for.

Eckerle Law offers a highest-quality and cost-effective alternative to the traditional law firm model for a wide variety of transactional and regulatory matters serving all your business law needs. Our experienced attorneys also provide a full range of compliance services for investment advisers, offering compliance tools that are tailored to fit the ever changing regulatory landscape as well as your business needs.

If your company would like to strengthen its business practices, please contact us today so we can leverage our experience to create real-life business and legal solutions to help your business thrive.