Founder shares refer to the equity ownership held by the founders of a company. When individuals or a group of people start a new business, they typically allocate a portion of the company’s ownership to themselves. These allocated shares are known as founder shares.
If you are a first-time founder or simply new to high growth, high performing companies, this article is for you: you will learn about the essential characteristics of founder shares and how you can use them to protect yourself from freeriding co-founders.
What is a “freeriding co-founder”?
Let’s take an example (one that we come across very frequently in practice, and as frustrating as this may be, it is important for you to know – as early on as possible! – that these things actually happen):
You and your other two co-founders have an idea for a new business and you decide to start it together, by forming a company (the StartupCo). When you incorporate, each of you gets an equal amount of shares in the StartupCo at the nominal value of 0.01 euros. As you embark on this journey, you are all highly motivated and work your a$$ off, and are extremely proud of your entrepreneurial progeniture. But then, 18 months in, Martin, one of your co-founders, gets an offer for his dream job and he decides to leave. Afterall, he has kids to raise…
This is frustrating for you and your other remaining co-founder. Why should Martin continue to retain 1/3 of the StartupCo? He’s getting a freeride off of your work! what can you do?
A founder who leaves, willingly or not (e.g. dies, is “fired”/you don’t see eye-to-eye anymore), the StartupCo can, knowingly or not, cause a lot of problems:
- Delay or block shareholder votes & decisions
- Retain a board seat & have a say in the StartupCo’s management
- Reap the benefits of your hardwork i.e. get the same payout as you from an exit from the StartupCo, even though they did not stay the course and do all the work, for as much and as long as you have
How can you protect yourself from a freeriding co-founder?
That is the question.
And the answer is: you sign, very early on, in the very beginnings of your StartupCo, ideally when you incorporate, a shareholder agreement. You can read more about what it is here.
But in this article, we want to focus specifically on two mechanisms that you should include in your shareholder agreement to protect yourself from leaving co-founders: the reverse vesting and the repurchase right mechanisms. How do they work?
Founder share “vesting” and “reverse vesting”
Vesting is essentially a mechanism for an investor to become a shareholder in the company, by acquiring shares during a given period of time, and according to a schedule agreed in advance.
Under the “vesting” mechanism the founders have to “earn” their share in the company by performing the work/tasks they have embarked upon by coming aboard the StartupCo month-to-month. This mechanism will be provided in the form of vesting clauses in an agreement with the other founders (shareholder agreement) and will typically be complemented by corporate amendments to the share capital structure of the StartupCo and option agreement/s.
The same vesting mechanism may be used with advisors and employees of the StartupCo.
“Reverse vesting” is the mechanism for a founder/existing shareholder to give back the shares if they leave the company, also inside a specific period of time, and according to pre-agreed conditions via the vesting schedule. In this situation, the founder receives all the shares upon formation of the StartupCo, at co-founding, however, these are only vested and secured at the end of the vesting period. If the founder leaves the StartupCo earlier/during the vesting period, then he or she will lose the part of their shares that is not secured.
In reverse vesting, co-founders sign, at the time of founding, shareholder and option agreements and certain special provisions may need to be provided for in the constitutive documents or by-laws of the company.
Additionally, it is worth mentioning that vesting or reverse vesting mechanisms are also often used by investors when they wish to retain the talent, know how and expertise of the founders of the StartupCo and ensure that they do not leave the company, especially immediately after they’ve invested in the company and they expect certain growth milestones to be met.
A vesting schedule is very similar to that in a stock option plan, where shares that haven’t vested can be repurchased by the company.
General repurchase right for founder shares
If you’re a founder, why would you want to give a general repurchase right to the company or the other founders? If you are the co-founder of the StartupCo, you want to have the general repurchase right if you have a falling out with one of your co-founders. The repurchase right is additional leverage for the company and the remaining founders to ensure a clean break up and completion if one of the founders is no longer involved in the company.
The buyback right in respect to the leaving founder’s shares may be granted to the other co-founders, where the company cannot repurchase its own shares, through different clauses provided for in the articles or by-laws of the company, alongside with the buy-back price and other terms and conditions applicable, and provided for in a separate, private agreement.
The bottom line
While in practice very few startups or founders conclude such agreements when co-founding the company, and most probably you will do this only when you get to VC funding, we strongly advise co-founders to always have these provisions and legal protections in place specifically in the early stages, when founding the first legal entity, in order to foresee and powerfully deal with issues that may come up down the line, when you’re in full growth and/or scaling-mode, and what you want more than anything is to have a smooth transition over a leaving co-founder (not to mention stay friends), but also keep your promises to each other as co-founders irrespective of any (new) shareholders/investors. Simply shaking hands over such things will have no legal enforceability with your future investors.
Last but not least, by dealing with these aspects upon company formation, you prevent a delay in the continuous functioning of your startup, avoiding general meeting of shareholders resolution adoption blocks, and instead showing your investors and employees and team that the company is not paralyzed by the mere walk away of one of your co-founders (though a key member him/herself), but rather that the show goes on.
If you need legal advice and support with drafting your company formation and co-founding agreements book a call with us.