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.

 

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9 thoughts on “Breaking Up Prior to Incorporation

  1. Pingback: Communication Inside Startups | Julian Baldwin
  2. Great post! I wish I read this post a while ago and had the foresight to sign a pre-formation written agreement…

    I’d love to hear your advice on a little predicament I’m in. A few months ago, I incorporated my company online, but I never got around to actually issuing any shares to the four founders (myself included). We made a verbal agreement to an equal equity split and thought that was enough for now.

    The three of them want to fire me.

    I believe they don’t have any weight, because I paid for the incorporation and other expenses. I’ve been acting as CEO, identified the market, made the presentation material, and done a lot of the footwork. I’ve also been involved with the company longer than other founders too. What should I do to resolve this issue and take back ownership of my company? Thanks!

    • Howard, you are in a tricky spot. Did one of you actually come up with the idea behind the company? If it was your idea and the idea is unique, you might be able to stop other others from using it, but that is not guaranteed. Had you actually gone ahead and incorporated and split the initial equity allocation equally, then the other 3 would indeed have the power to “fire” you. Shareholder voting works that way absent a written agreement saying something else. You would be able to keep any shares that had vested (assuming you all had vesting agreements). That is the whole point of vesting agreements. But 75% (them) vs. 25% (you) is, well, just that. I suggest you talk with a start-up lawyer (do you have access to one?). My guess is that you will end up with a small chunk of equity, but that going forward you won’t be involved in the company. Like I wrote above, if the actual company idea is yours, then your position is better. You could restart a new company based on the same idea.

  3. Hi Mr. Shulman, thank you for this post! Like the poster before me, I wish I would have read this sooner. I would be so gratefule if you would share your advice on my current situation.

    Junior year in college I had a idea for a web application I wanted to build. I took an entrepreneurship class my final semester in college (Spring 2012) to further develop this idea. We were required to work in teams so I invited a classmate to work with me on the idea. We worked on the idea during the semester (wrote a business plan, created some basic wireframes, even had some student developers at our school build a very basic prototype which we ultimately discarded). After we graduated we planned to continue working on the idea. For a couple of months we did until things “fizzled out” and we stopped communicating for a couple of months.

    I called him Spring 2013 to formally tell him that I wanted to continue to pursue this idea without him. He agreed and said that I was always more passionate about the idea anyway. He said he was thinking about a couple of other new ventures to pursue and we parted ways amicably. Throughout our time working together I don’t think we ever came to a conclusion about equity split (we talked about it and agreed I deserved more since it was my initial idea but I think that was the extent of our agreement over equity). We never formed an entity and he never paid for any expenses.

    Today, I am pursuing a variation of my initial idea in college. I am working with a new partner (we have a written pre-incorporation agreement in place outlining the equity split and vesting schedule) and we are getting ready to launch our site. My concern is that he will seek ownership over what I’m doing today. Do you think my former classmate has any legal right over what I’m doing today?

    Thank you so much. Go big red!

    • Very hard to say and even if I said “no” there is no way from stopping him from making a claim. The only way to get 100% certainty is to get him to release any rights. Maybe you give him a small % and have him sign a release. But even bringing it up is risky. Assuming you used none of his work product or ideas, then chances are you are ok, but again, he can always make a claim and cause you a headache.

    • I actually don’t because most of the companies in my VC world are corporations. Corporations don’t have operating agreements. Operating agreements are only for limited liability companies. They have to be drafted when the LLC is formed. I find LLCs very cumbersome for anyone that wants to raise $$ from outsiders (with some exceptions for real estate holding companies and similar entities). thx.

  4. Have a question.

    1) Started working on an idea and coding for first x months
    2) After x on wards opened a new company with couple of co founders but no agreement signed
    3) Haven’t reached any agreement after couple months since x. But new code was developed since then. Using the original code written by me.
    4) Now we are breaking off and the question is who owns the code and IP

    Thanks in advance.

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