How to protect and prepare - case of a leaving cofounder
With change being the only constant, the question is not whether but when and what changes you will have to deal with.
Within the cofounding team, a very frequent, very disruptive, but often unforeseen scenario is a leaving cofounder. How to handle it? The best answer is by being prepared for the case it does happen - BEFORE it happens.
And it happens more often than you will want to know. There are plenty of famous examples of cofounders being fired or leaving, with or without the businesses trying to reclaim their shares, ranging from Steve Jobs (Apple), Sandy Lerner (Cisco), Andrew Mason (Groupon), Eduardo Saverin (Facebook) … – the list is endless. So whether the story is famous or not, big or small, early or later – cofounders leave. It is a fact of life.
From all the challenges that you need to address, the most critical are:
#1: A cofounder leaving creates an operative or management hole in the business
# 2: depending on what you have or do not have in place for intellectual property arrangements - you might need to mitigate potential intellectual property and strategic know-how leakage.
#3: you need to deal with the leaving cofounder’s ownership in the business!
LEAVING COFOUNDER EQUITY
While there are many possible reasons why a cofounder leaves, what is important is to fairly and in a balanced way protect the interest of all parties - the leaving cofounder, the remaining team and the company.
The starting point is to have in place the equity recovery framework, frequently also called *good/bad* leaver framework BEFORE this situation happens.
When is this relevant? It is relevant when the situation happens, however, is is best put in place together with equity allocation, respectively when incorporating your company - as part of a cofounder agreement.
HOW TO IMPLEMENT THE LEAVER FRAMEWORK
# Step 1: Define good and bad leaver
There are 4 main scenarios how a cofounder can leave a company.
He can be fired for no good reason
He can be fired for good reason
He can resign for no good reason
He can resign for good reason
To determine the good and no good reason within the leaver framework you can choose from the following options:
Define typical scenarios upfront - for example the bad leaver is a founder being fired for non-performance or the founder resigned to accept a better offer from the competition
Define a values framework upfront - criteria on which you will base the categorisation
Refer for guidance to employment law jurisprudence which works with similar concepts in labor law
# Step 2: Decide equity consequences for Good and Bad leaver
Based on this characterisation, leaver frameworks typically distinguish between good and bad leavers and have different consequences for the different categories. The aim is to reach a fair protection of the interest of the company and of the leaving founder.
If the founder is leaving for what is a ‘good reason’, he is protected and can either keep his shares or get a buy-out offer from the company.
If the founder is leaving for ‘not a good reason’, there is typically a punitive element and he loses part or all his shares as a penalty for damaging the company.
# Step 3: Link it all together
With implementation the devil is in the detail. The leaver framework needs to include several elements and should be aligned with all the other elements of the team set up. Elements include:
Defined cofounders’ roles and responsibilities along with milestones (essential if you need to evaluate performance for good/bad leaver categorisation)
Agreement on the methodology of the company valuation - essential for any buy-out offer from the company
Agreement on the equity consequences: who gets the right for the equity remaining after the leaving cofounder
Voting and governance: for example, how will the team decide on the good/bad leaver characterisation (typically with abstention from voting for the leaving cofounder)
This may sound complex, and it definitely is not easy, but it is infinitely easier that to have these discussions when the situation happens. More often than not, especially in an early stage, such a disruptive event could mean the end of a promising venture.
One of the dangers of not having the leaver framework in place means that you have a very high risk of ending up with so-called ‘dead equity’ – people owning part of the business who are no longer involved with the business, or being stuck with a non-performing cofounder. This is problematic as it impacts the ownership, decision making and the amount of equity you have available for further growth. In some cases this could even mean the inability to raise external investment or onboard new cofounders.
Be safe, fair & prepared.
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