Legal Tidbits for Start-ups: Splitting Up Need Not be Hard

 A few years ago, three young enterpreneurs  looked at me with amusement across the table at Starbucks :  "We don't need a stockholders' agreement.  We've been friends since college and this venture has been our dream for a couple of years."
 
"It's not a destructive thing," I said. "It anticipates and solves issues in advance, setting expectations and keeping the partnership stronger."   After some discussion, the enterpreneurs agreed, and signed an agreement.  Only a few months passed when I received a call from one of the partners -  he wanted out.  His fiance was accepted in med school, and he needed a paying job, so he joined a major consulting firm.  In the process, he forfeited most of his founders' stock, enabling the remaining partners to offer some of those shares to a new recruit hired to "plug the hole" that the departing enterpreneur left. The stockholder agreement provided the roadmap, and the company survived with minimal pain.
 
This story has a happy ending, but  some  others do not.  Business partnerships, like marriages, start out with passion, but  sometimes end in disappointment. Denial of this possibility can lead to disastrous results.  It's far better to anticipate possible issues in advance and create a structure for resolving them in a constructive manner.  Here are some suggestions.
 
-- Make sure that all IP is assigned to the company.  Quite often there are ideas, trade secrets and even patentable inventions that are developed during the earliest stages of a business, as founders brainstorm about markets, applications, processes, etc.  The legal entity is generally formed later.  All founders - and anyone else involved in the venture, be it informal consultants, advisors and even girl and boyfriends who had access to IP - should sign an Assignment and Nondisclosure Agreement. Just remember: if anyone can prove that an invention was not properly protected as a trade secret - as in being freely discussed with friends and advisors - can invalidate ownership rights.
 
-- Develop a thoughtful equity allocation plan. Not all founders are equal.  Each brings different values to the table.  If one founder is perceived as getting more equity than he deserves (probably true for the finance guy in my story), the resentment will fester, and ultimately undermine the relationship. Look at long-term needs and capabilities, and apportion equity based on aggregate expected contributions.
 
-- Tie stock ownership to meaningful milestones. Some founders - such as the inventor of the fundamental technology - bring significant value to the venture at its very conception. Others bring capabilities  - such as finance, marketing - that might be more relevant in the subsequent evolution of the company.  Issue stock to all founders, but subject them to restriction ("vesting") based on the timing of the value creation expected by each founder.  Then, if someone leaves the venture before she contributes the expected value, her shares would be forfeited - and available to her replacement who will need to produce the specific value that his predecessor did not deliver.  For example, issue 30,000 shares each to the inventor and the finance person, but provide that the inventor forfeits 15,000 shares if she leaves within one year, whereas the finance person forfeits 25,000 shares.  Both founders must continue to build value after receiving their shares, but more of that value may be "on the come" for the financial founder than the inventor.
 
-- Incorporate reasonable two-way termination clauses in the Stockholder Agreement.  Both company and founders need to be protected against unexpected events: personal and financial circumstances that require a founder to move on; disappointing performance;  lack of compatibility among founders; or demands by angels or VCs that a heavy hitter be substituted for one of the original members of the management team. Proper safeguards, including both fair descriptions of various termination events and fair procedures to determine consequences, not only minimize conflict when someone departs, but also set a a constructive atmosphere for the enterprise.
 
-- Remember the impact of dilution.  If one founder leaves after a series of additional shares were issued to management, angels and even VCs, the percentage of equity that his forfeited shares represent is effectively redistributed to all other stockholders.  This might come as a surprise to the remaining founders, who may have expected the return of the forfeited shares all to themselves. There are solutions to this problem, though they're somewhat awkward.  Of course, keep in mind that any shares (or options) subsequently issued to the person replacing the departed founder would also come out of all shareholders' hide.
 
-- Don't reinvent the wheel.  All of these issues have been addressed and solved many times over.  While no agreement is perfect, a well-written set of documents reflects the accumulation of many years' worth of experiences, and balances simplicity (and cost) against covering each and every contingency, however remote.  Create a roadmap that's clear and accurate - but avoid specifying every possible sidestreet or detour.
 
No one expects a romance - whether in personal or business life - to end in conflict, though  some  do. And no one should create conflict by obsessing about the "what -ifs" of a possible breakup.  Thoughtful planning enhances and strengthens the relationship and avoids many of the pitfalls of a possible split-up.
By Gabor Garai. Gabor is a venture capital and emerging technology attorney practicing in Boston. He is chair of the Private Equity and Venture Capital Practice of Foley and Lardner, a national law firm that ranks #1 in BTI's survey for delivering superior client service and value. www.foley.com
The views expressed in this posting are those of the author and not necessarily those of Foley & Lardner LLP or its clients.