How to keep a founder in a startup? — legal column from REVERA
About the practices that investors resort to to retain the founders of IT companies – in their material for App2Top they toldAlyona Potorskaya and Ekaterina Yakoltsevich, employees of the REVERA law firm.
Alyona Potorskaya, Senior Associate of REVERA law group, and Ekaterina Yakoltsevich, Associate Associate of REVERA law group
When buying a real sector company, the main aspect that the investor pays attention to is real estate, the customer base, and contracts concluded. The situation will be completely different if an investor buys a stake in an IT startup. IT startups, as a rule, do not have their own permanent customer base, they may not even have a profit for the first years, because, for example, they are at the stage of developing a mobile application and it does not bring them profit. The main asset of a startup is people, and an experienced investor understands this and is always aimed at keeping key people in the company for as long as possible after attracting investments.
Below we have analyzed the main legal instruments of English and American law that are used to protect an investor from the departure of a funder from a startup.
Lock-up
Lock-up is a legal instrument that is traditionally fixed in a shareholder agreement and obliges the founder to refuse to alienate his share to another person without the consent of the investor for a certain period of time. Lock-up prohibits not only the traditional sale, but also donation, exchange, concession.
When fixing such a legal instrument as lock-up, it is important to pay attention to the following points:
- term. Since it is impossible to completely block the departure of the founder from the startup, it is important to determine the period during which he needs to remain a shareholder of the company. When limiting the right of the founder to sell his share, investors traditionally insist on 2-3 years from the moment of his entry into the business. However, everything depends on the agreements between the parties. And there is always an option for the funder to shorten the term of such an obligation;
- the parties to which the lock-up will apply. Depending on the structure of the management structure in the company (the order of decision-making, the presence of a collegial / sole executive body, its composition), there are various options for imposing lock-up restrictions. Thus, the following can be distinguished from the widespread:
- lock-up distribution to all funders;
- extending lock-up only to founders who own a certain percentage (number) of shares;
- extending lock-up only to founders who simultaneously hold a position in the company (for example, directors, CEO, CFO, etc.);
- any combination of these variations (for example, a founder who owns more than 10% of the stake and holds a senior position in the company).
- definition of other lock-up restrictions. As one of the options that is often used when securing a lock-up, it is the release of a certain percentage of the share from the lock-up obligation. So, for example, a ban is used on the sale of a certain percentage of the founder’s share so that a significant part remains controlled by the founder and his participation in the startup remains.
Often, the investor’s goal is not to protect a startup from a founder’s exit, but to protect a startup from becoming a toxic person’s shareholder. Toxic persons include persons included in the sanctions lists, convicted of economic crimes, etc. – their presence in the shareholders of the company will cause reputational losses to it.
If an investor needs to protect himself from such situations, then it is impractical to use lock-up. In this case, it is better to replace the lock-up with an indefinite ban on the alienation of a share to such a toxic person.
Westing shares
Another common legal tool used to retain a founder in a startup is the westing of his share. In other words, vesting a share means receiving a certain number of shares depending on the time period during which the founder is in the startup.
Westing may be:
- Ordinary. With this type of vesting, shares are accrued over a certain period of time in equal shares (monthly, quarterly, annually). For example, the founder is promised 3,000 shares of the company, 1,000 of which will be accrued annually (or 83 monthly) for three years. Thus, the motivation of the founder is to stay with the shareholders for a longer amount of time in order to eventually own more shares of the company and get a larger profit when selling his share.
- Reversible. With this type of vesting, the founder immediately becomes the holder of the entire number of shares promised to him, however, if he leaves the company earlier than the vesting ends, the size of his share is adjusted in proportion to the time he has been among the shareholders. If we use the example from the previous paragraph, the situation will be as follows: the founder is promised 3,000 shares, subject to reverse vesting in three years. After one year, Founder decided to resign from the shareholders. In this case, he has the right to receive only 1/3 of the promised share, i.e. 1000 shares.
Condition (good / bad leaver)
As one of the limitations of the foundation’s exit from the startup, it is necessary to determine the conditions for the foundation’s departure from the startup, as well as the conditions when such care is acceptable and when it is not.
Possible examples of “respectful” and “disrespectful” reasons for the departure of the founder:
As “valid” reasons for leaving the company, objective reasons are identified that may hinder the performance of his functions (for example, the illness of the founder or his close relative), a reduction in the annual minimum wage (if he holds any position), etc.
“Disrespectful” reasons will be considered (1) the refusal of founder to perform the duties reasonably expected in connection with his function, (2) conduct that discredits the company or causes significant damage to the reputation of the company, (3) unfair behavior in relation to a material issue or a deliberate attempt to harm the company, (4) a criminal act of founder which will adversely affect the reputation of the company.
The reason for the foundation’s departure from the startup is important, because when using the legal instrument in question, the shares of the outgoing foundation are treated differently, and depending on the reason for the foundation’s departure, it is classified as good or bad leaver. It is on the basis of this classification that the privileges on which the founder can count in the event of a withdrawal from the shareholders depend:
- Good leaver. When exiting for “valid” reasons, a bona fide funder can count on (1) profit from the sale of shares that were not accrued to him during the vesting period (if it is not completed), at a fair market price, (2) compensation. Compensation is calculated depending on the number of shares that he received on the westing, or calculated according to a pre-prescribed formula (for example, the founder can receive a percentage of the annual turnover or part of the investment in the next round).
As a result: the founder leaves the shareholders with a certain number of shares accrued during the westing period, and also receives money from the sale of shares that were not accrued to him during the westing period, and in some cases can even count on compensation.
- Bad leaver. When a founder leaves for an “irreverent” reason, he must sell all his shares received during the westing period to other shareholders or the company. Also, he does not profit from the sale of shares not received during the westing period (if it is not completed).
As a result: the founder leaves the startup without shares of this company, and receives only profit from the sale of those shares that were accrued to him during the vesting period.
In general, there are a large number of legal instruments under English law that protect an investor from the departure of a founder, and we have described only some of them that are most often found in the regulation of relations between shareholders.
