Breaking Up Prior to Incorporation

What happens when a purported “full time” co-founder decides to scale back prior to actual incorporation of the legal entity.  Let’s call this person Founder L (L for “leaving”).  And let’s call the other founder Founder C (C for “continuing”).  Let’s assume only 2 founders.

The situation, predictably, can be anything but harmonious. Originally, let’s say that Founder C and Founder L verbally agree (prior to formal entity formation) that the initial equity split between them would be 51% to Founder C and 49% to Founder L.  They did not discuss vesting originally (a mistake).  To complicate matters, each of Founder C and Founder L put in $5,000 to get the yet-to-be incorporated company off the ground (funds to order some inventory and file a provisional patent application, for example).  At the time of this cash infusion Founder C and Founder L were getting along fine and Founder L was playing a meaningful role.

About 4 months or so after the initial cash infusion by each of them and the verbal agreement on how equity would ultimately be split, things start to head in the wrong direction.  Founder L is not pulling his weight; he is happy to talk strategy and suggest tasks for others, but is not willing to get his hands too dirty.  Founder L is the one worrying about the day to day, etc.   Founder L decides to pursue a full time job.  Founder C, feeling that Founder L was not worth too much to the business anyway, hires some other people.  Founder C, being the agreed to majority owner of the to-be-formed entity, basically tells Founder L that there is no room for a part time founder and offers Founder L a small equity stake (5%) for past contributions and also offers to repay, when the company can afford it, his $5,000.  This starts an interesting process.

Founder L’s position is that his $5,000 cash contribution at inception was an investment in the to-be-formed entity and that he is therefore entitled to a larger piece of the company (he wants 25%).  No doubt that Founder L’s cash infusion was important to the non-formed company.  But Founder C justifiably feels that 25% is a huge piece for $5,000.  I would tend to agree with her.  Regardless, unless agreement is reached, the company is now crippled and maybe dead.  It is certainly not fundable with an outstanding dispute as to share ownership (I bet the early investors in Facebook had no idea about the ownership disputes there when they first invested).

This situation raises some interesting issues – very common issues unfortunately that lead to sub-optimal outcomes all the time and ruin friendships.  Let’s look at some of the issues and solutions:

1.  What is a good way to plan ahead for founder breakups before entity set up?  The best thing to do is have a “pre-formation” written agreement that spells out who will own what, how shares will vest over time and what actually happens if someone decides to leave prior to entity formation or if the founders simply decide that they don’t want to work with each other any longer and one of them gets fired.  This is particularly relevant when you have 3 or more founders and no one owns a majority as 2 can “gang” up on the other one and fire him.

2.  Who is in charge prior to entity formation?  The pre-formation agreement should also spell out who is in charge (acting CEO).  This will typically follow the equity split so in this hypo Founder C would be in charge.  If you have no majority owner, the agreement as to who is in charge is heightened in importance.  Yes, everyone is pulling the same oar, but defining roles is key.

3.  How much does a cash infusion actually purchase of the to-be-formed entity?  My default answer is going to apply here as well – it depends on what the pre-formation agreement says.  And it definitely should address this critical issue.  In the hypo above, $5,000 for 25% seems really high to me as Founder L will be a serious free rider if the company is successful.  Sure, he will be diluted when the company raises funds in the future, but could still end up with a meaningful stake at exit.  And, agreeing that a cash infusion buys nothing outright is perfectly fine.

4.  What if Founder L and Founder C don’t agree on the breakup terms?  Chances are that the company is toast.  Founder L will likely realize this and that would give him some bargaining power.  Founder C could always form the entity and cut out Founder L completely as an equity holder, but the risk of Founder L suing is real and this risk will hamper the company’s ability to raise funds if it is disclosed.  What we can hope for is that Founder L and Founder C are rational, come to terms and compromise.  I doubt both will be delighted with the outcome, but the alternative is likely worse.

If this brings up additional questions for you, let me know and I will try to answer.  Enjoy the rest of the weekend.