How Founders (Should) Break Up

Nutshell: There are two ways for founders to break up. One preserves everything those founders built together, including a chance of a successful outcome. The other can bring everything crashing down, ruining months, even years, of hard work, and damaging lives in the process. Simple decisions made at the beginning of the relationship dramatically influence which outcome you end up with.

Worthwhile reading:

First off, like any good lawyer, let’s get our definitions straight. I’m talking about Founders (capital F) in this post – meaning the people who were there at the beginning of a startup, or at least well before it became something investors wanted to buy a part of. For better or for worse (probably worse), the term “founder” has become just another title that gets negotiated by early hires to help artificially build their street cred. If you showed up to a startup with your own lawyer, or with data on compensation packages, you’ve gone through very different dynamics from actual founders.

The Honeymoon Period – Setting the Foundation.

Know and trust each other. 

It sounds sappy, but it’s unquestionably true: starting a startup with a cofounder is about as close (emotionally) to starting a family with a spouse as you’ll ever get, without actually starting a family with a spouse. CEOs refer to their startups as “their baby,” and they’re not kidding.

You have to go in totally trusting the other person, and committed to the good of the startup as something separate and higher than your own self-interest. If you don’t, you’re demented and asking for a world of pain.  I look at our portfolio of startup clients, and the vast majority (but not all) of the top ones were started by either (i) two or more cofounders who are real friends, or (ii) a single founder with total control. In each case, minimal time is spent arguing over equity %s or vesting schedules. It doesn’t mean everything is lollipops and sunshine, but everyone knows their role. Founders who are mere ‘business partners’ generally underperform compared to founders with a strong, personal relationship.

Paper it.

Different people have different approaches to marriage. Some are big on prenups, and others aren’t. But for founders, sign some damn contracts. Standard ones that shouldn’t take startup lawyers very long to produce. They should have:

  • Clear language regarding the Company’s ownership of all IP;
  • A vesting schedule (~4 yrs), with a cliff (~1 year);
  • Non-solicits and (depending on the state, but def. if you’re in TX) non-competes;
  • Language about returning all company property on termination; and
  • No ambiguity as to what happens if/when a founder leaves voluntarily or involuntarily.

I’ve often heard founders say something like “we don’t have VCs yet, so we don’t need vesting schedules.” Totally wrong reasoning.  The vesting schedule is there to ensure that if someone walks away before a meaningful milestone (especially if they walk away angry), they can’t take with them any chance of the Company’s ever succeeding.  Try raising VC money with 40% of your cap table held by an inactive founder.   The cliff serves a similar purpose – it puts in black ink what everyone should already understand: this is a long-term project, and if you’re not in it for the long-term, you shouldn’t be signing up.

Papering this kind of arrangement among a good group of founders should not be controversial.  If I start seeing founders bickering over vesting schedules, or random contingencies in their founder docs, my views on their long-term prospects are automatically dropped several notches.  I’m also not a fan of founders negotiating “single trigger acceleration” among themselves – “if you fire me, I get X% of my vesting schedule accelerated”.  If you’ve chosen the right founders, no one should be getting fired unless it’s the right decision for the startup. And if it’s the right decision for the startup, you shouldn’t be walking away with more than what you actually earned.

When the Honeymoon’s Over – A Clean Break.

I’ve said it before, and it’s worth repeating: Contracts Aren’t for the Honeymoon; They’re for the Divorce.  While there are hundreds of reasons why a founder might break away from a startup, if the proper foundation was set, there should be minimal legal ambiguity as to what happens to the startup when that founder is gone.  IP stays, as do all unvested shares. The departing founder keeps what she vested. Deliver everything to the company relating to the startup – hardware, code, login credentials (which should be changed after the departure), etc. Don’t try to take any employees with you, or build a competing product. Move on.  

A simple letter stating the definitive termination date should be delivered by the Company to the departing founder, spelling out what the post-termination equity holdings will be, and delivering the small amount of money needed to repurchase the unvested shares.  It’s also often considered a best practice to give a departing founder a small “sweetener” – a few extra shares, or a little cash, in exchange for signing a full waiver and release of all claims, including a non-disparagement clause (you can’t start insulting everyone on twitter).  Hopefully there aren’t any real claims to waive, but when VCs diligence the company and see an exit of a major founder, it gives them a bit of comfort to see that release signed.  Founder lawsuits have a way of creeping up once a few zeros are added to the valuation.

Emergency Maneuvers.

Not everyone is so lucky to have a clean founder breakup.  Sometimes angry founders refuse to return company property, or refuse to sign documentation relating to their departure.  I’ve even seen situations in which founders are caught maliciously hacking into servers.  Prepare yourself.

If the proper legal foundation was set early on, a refusal to sign anything shouldn’t be a serious problem. Good founder docs are drafted so that simply e-mailing a termination notice, along with a check, gets everything material done. Signatures on termination docs is nice, but not essential. As to other things like refusing to return property, usually the first step is to have some personal conversations about how small startup ecosystems are, and that reputations take a long time to rebuild. A nastygram from your corporate lawyers can help too.  If all that fails, it may be time to get other lawyers (litigators), or other authorities, involved. Hopefully it never gets there.

But if you didn’t do what you were supposed to do when the founders first got together, and now you have an angry, defiant founder who perhaps still owns rights to company IP, or has walked away with half the cap table… well, you fu**ed up. Is this the end of your company? Not necessarily, but it definitely could be. Talk to your lawyers. Maybe there’s enough of an e-mail trail making it clear that IP was intended to be transferred. Maybe a recapitalization (a ‘recap’) is possible to wipe out everyone’s equity and start fresh. Maybe you can eventually convince them to sign the right docs now.  Maybe. Regardless of the outcome, you’re going to be paying your lawyers a lot more (like 20-100x) to clean it up than you would’ve paid to do it right on day one.

Only idiots start families with people they don’t trust, or truly understand. Founders who start companies with people they don’t trust, or who think it’s unnecessary to paper things properly, aren’t much smarter. Find the right cofounder, and then sign some damn contracts. Then hope you never have to read them again, and start building.

Startup Lawyer’s Poker: Fee Deferrals

Nutshell: Startup-focused law firms with well-developed client bases are able and willing to bet on (the 1% of) startups by deferring their fees, but founders should understand what they’re signing up for when agreeing to those arrangements.  In many cases, fee deferrals are just clever ways for firms to “lock in” already de-risked founders and have them ignore massively marked-up price tags on legal services.  Think before you drink the kool-aid. 

It’s no secret that one of the largest expenses that early-stage startups face from their very early days is the cost of hiring competent lawyers. The reason for this is simple: “cloud” economics don’t apply to people. Deploying a SaaS startup has become way cheaper than it was 10 years ago because of all the “X as a Service” that founders can leverage instead of having to invest significant amounts of capital on in-house technology.  But, unsurprisingly, developers still aren’t cheap. Being a good developer requires years of training and unique talent, and being human requires paying for stuff.  Good developers cost real money.  Good lawyers, like good doctors, cost real money.  Anyone suggesting otherwise is attempting to defy the laws of physics.

All that being said, readers of SHL know that there is a lot that smart founders can do to avoid over-paying for legal services:

  • Are you just one or two founders working on an MVP? – Use Clerky and/or, if you need a lawyer, hire a top-tier boutique firm that specializes in early-stage tech, and be careful with generalist solo lawyers.
  • Do you need specialist lawyers for things like trademarks, patents, or other specialty counsel? – Resist the firms that VCs try to force you to use, which are usually very large firms that over-charge clients by $200-300/hr in order to fund their pyramid structures, outdated bureaucracies, and bribes sponsorships of accelerators for funneling companies through them. If you think an extra $200 for every single lawyer hour won’t have a material impact on your runway, do the math again.

If I wanted to get cash-strapped founders to completely ignore the real cost of startup legal services and get them to pay my 2-3x inflated price tags, what would be a great way to accomplish that? Answer: defer my fees until they are less strapped for cash. 

PayDay Loan Meets No-Shop Clause

For many law firms, the fully transparent bargain in a fee deferral can be summed up as follows:

  • Assuming your bill doesn’t go above $X (often something like $25-50K), you don’t have to pay us anything for at least 6-12 months, or until you raise $Y (often a range of $100K-$500K).
  • In exchange, please ignore the fact that everything we charge you will be massively marked up. And we’d also like 1% of your common stock.
  • Also, don’t think about using other law firms for anything while our fees are being deferred – we can’t afford our deferrals if every client goes and hires those lawyers that left our firm 2 years ago and now work for $250/hr less than what we’re charging you for less experienced lawyers. If you do, the bill needs to get paid. This isn’t UNICEF.  The Life Time Value (LTV) isn’t there if all you’re using us for is a fixed-fee formation package.

If a major law firm has made this kind of offer to you, it’s likely because you’ve signaled to them that this “bargain“ is a good deal on their end. Usually, that means you’ve been accepted into a major accelerator, received interest from an investor, or have otherwise been “vetted.” You’ve been de-risked. Smart founders who are lucky to find themselves in this position should obviously ask: if I’m de-risked, is this actually a good deal for my startup?

Be Smarter About It

In startup law, successful late-stage clients cross-subsidize early-stage clients that can’t yet pay their bills. This economic reality ensures that, as long as small firms are stuck working with B-players, the firms with A-clients will always be able to win more A-clients by offering them fee deferrals that the smaller firms simply can’t match.  Startups that don’t want to be bankrupted by lawyers, yet also don’t want to be locked down by gilded handcuffs, really then have two options:

  • Find the efficient A-lawyers, and budget for their services. – Well run focused firms can be dramatically cheaper on early-stage services than traditional firms (and, frankly, better quality), particularly those small firms that regularly work with startups and have optimized their pricing structures for those kinds of companies.  Budget for their services just like you budget for anything else. The truth is you rarely need that much lawyer time before your seed round.
  • Find top-tier smaller firms that are willing to defer. – Remember, only firms with solid client bases can afford to defer their fees for good clients. Many small firms simply won’t do it, but some will.  The deferrals won’t be as large (because your LTV for them is smaller – they aren’t trying to do everything legal for you) but it doesn’t need to be, because the bills are lower.

The evolving law firm ecosystem that I’ve written about is increasingly moving up-market, working with higher-quality clients that once were too afraid to use anyone but the established law firm brands. That means those smaller, more nimble and efficient firms are increasingly able to offer their own “incentives” to attract top-tier clients, without the massive costs of shackling yourself to a single, large full service firm. 

To be honest, I’ve always viewed fee deferrals as an unfortunate, but necessary evil in the startup law space; a kind of smoke and mirrors to distract everyone from the very real problems that traditional law firms are unwilling to address. Does E/N do fee deferrals? Yes, unlike most firms our size, we defer for a small segment of our clients.  I’ve picked enough winners and turned down enough losers to trust my instincts on deferrals.  But if you ask me about deferring my fees, my initial response is always going to be “let’s talk first about how we’ve made top-tier startup law actually affordable.”

How Founders Lose Control Of Their Startups, Apart from Ownership

Summary: There are many ways, apart from ownership %, that founders slowly lose control of their companies. Some of the more obvious ones get spelled out in term sheets, but professional players in startup ecosystems know how to use more subtle mechanisms to erode founder control.

Seasoned founders and startup lawyers know that there are really two things that matter most in negotiating a term sheet: economics and control.  In other words, from the perspective of a founder, (1) what % of the Company will I own after the deal closes (and, more specifically, what % of exit proceeds do I get), and (2) whose permission is needed to make key decisions? Of the “control” terms, there are explicit ones, like protective provisions,  that competent founders know to focus on.  But there are more subtle aspects, like the composition of the Company’s advisors, and even who the Company’s lawyers are, that when ignored can significantly erode the ability of founders to maintain influence over their companies; particularly in high-stakes situations when there’s significant internal disagreement.

As I’ve written before, being an entrepreneur raising capital means learning to give up control. That’s a given. However, I’m very much a believer in transparency and having your eyes wide open. By educating yourself, you ensure you give up control at the appropriate time, and with fair terms; instead of with subtle power plays that slowly hand control to other people without you even noticing it.

The More Obvious Forms of Control

  • Voting Thresholds and Protective Covenants – These are typically spelled out in stockholder agreements and organizational documents. There are 1,000 ways to draft them, but they basically boil down to: you can’t do X without getting approval from stockholders holding Y% of the Company’s overall capitalization, or a specific % of various classes of stock.
  • The Board of Directors – Who is on the Board, and who has the ability to elect/remove people on the Board? The Board is the core governing body of the Company, which means nothing serious happens without their approval. In a 5-person board, whether founders (common stockholders) elect 3 directors or 2 dramatically alters the power dynamics of a startup.

The Often Overlooked, But Important Control Mechanisms

While voting power and board composition are definitely the most important issues, I always advise founders that maintaining control/influence over the companies they started is much more nuanced than what gets spelled out in a term sheet.

How “Independent” is Your Independent Director?

It’s very common for VC-backed boards to have an “independent” director – usually an industry expert that gets elected by both the common stock (founders) and preferred stock (investors).  However, it’s also fairly common for VCs to suggest that the “independent” director come from their own network of executives.  In judging whether their VCs recommended “independent” is the right person, founders should absolutely include the loyalty of that director to the VCs in the calculus.  He’s in their network, and knows that keeping them happy will mean more influential board appointments in the future. If a founder CEO is well-informed and connected in her startup’s own market, she likely has her own ideas for more independent directors. Put them on the table for discussion.

Board Observers – Who is at the Board Meeting?

Investors often will ask, in addition to a Board seat, for one or two board “observer” positions; meaning, at a high-level, non-voting people who can nevertheless attend board meetings and (usually) engage in discussion with the board. The presence of board observers matters and absolutely will influence discussion on board-level issues, even if they ultimately can’t vote. Don’t hand them out without understanding how they alter a founder’s influence at meetings.

Whom do your lawyers work for?

I’ve touched on this issue before here: Don’t Use Your Lead Investor’s Lawyers. There are hundreds of scenarios in which, in the middle of high-stakes decisions and disagreement among decision-makers on the right (or legal) course of action, founders will turn (protected by attorney-client privilege) to company counsel for advice – what’s legal?, what are the consequences?, what are my options?, what’s “market?” etc. etc..  Many times the “right” decision for the Company is one that won’t sit well, and even piss off, certain groups on the cap table.  You don’t want lawyers who work for those people.

“Don’t just go with the lawyer that the VCs insist upon. These lawyers will work with the VC on a hundred financings and with you on only one. Where do you think their loyalties lie? Get your own lawyer, and don’t budge.“ – Naval Ravikant, Lawyers or Insurance Salesman?

Despite arguments from certain investors and lawyers who claim that the above is a non-issue (you can imagine why), most founders immediately recognize the problem when this reality is described to them.

Where do your advisors and executives come from?

The theme of “pay attention to loyalties” carries on into a Company’s advisors and outside executive hires.  Where did they come from? Who got them this job, or their last job? Are they all part of the same investor group or business network? The conversations they have with you (the founders) will not be the only ones they’ll be having. Pay attention. Careers are long, much longer than the life of a single startup.  Advisors and executives, even those with strong ethics, pay attention to who can get them their next position when their current one exits.

Nutshell: Voting control matters, but it isn’t everything. Loyalties, particularly long-term loyalties, drive human behavior. Don’t be lazy and let every influencer (director, executive, lawyer, advisor) in your company come from the network of a single investor group. Smart ecosystem players know that’s one of the best ways to gain influence over a company without putting anything on paper. Leverage peoples’ contacts, and of course contacts will overlap, but make sure you ultimately have real diversity of perspectives to turn to.  Otherwise, when it really matters, a dozen back-end conversations will end up with really only one voice whispering in your ear.  

It’s precisely when the stakes are highest that a founder needs brutal honesty from advisors and counselors. And nothing ensures honesty like transparency and true independence of viewpoints. Make sure you don’t lose it.