Co-founders, separating, is a harsh reality in early-stage companies, due to a plethora of reasons ranging from differences in opinion with regards the conduct of affairs, daily administration and management of the Company, to the relationship not working out organically, or in some instances simply due to personal reasons. The trouble in paradise gets worse when such separation is due to bad reasons such as non-compatibility between the founders and their inability to work with each other.
Structuring exit terms of a co-founder could be quite challenging, given the same is greatly dependant on ownership stakes, involvement in finances/intellectual property and/or other functional/operational/strategic matters in the company. As such, separation terms need to be carefully negotiated and structured to protect the rights of all parties involved and especially that of the company. We typically suggest entering into and executing a written agreement clearly laying down the terms of the separation and settlement thereof. Getting to the signature stage of this document becomes relatively easier if there is any signed founders’ agreement/shareholders’ agreement in place. To refer to our earlier post on founders’ agreement please see here.
There are various points of consideration that should be kept in mind for structuring separation terms, which, many a time, go a long way in either making or breaking a company.
If you are a continuing founder, you may begin by asking yourself the following questions:-
- How much equity is the exiting co-founder holding?
Typically, if there is a founders’ agreement/shareholders’ agreement in place, vesting related clauses get triggered and that serve as a good starting point for negotiations/discussions on the rest of the points. In the absence of such agreement, equity distribution discussions may prove to become major roadblocks as emotions run high during such events. While it is true that equity is the most preferred compensation mechanism in early-stage companies and therefore, it is inevitably required for attracting talent and getting future co-founders, it is also only fair to ask for what one deserves. Continuing founders may push for a complete exit, but exiting co-founder would want value for sweat, time, reduced remuneration, etc. Also, any retained equity by the exiting co-founders may be considered as “dead equity” in an early stage company, wherein investors invest in the caliber and business idea of the founders, more than anything else.
There are various means through which equity of an exiting co-founder is given back to the company/remaining founders/incoming co-founders depending on various parameters, and especially the value that the company has generated till the time of such exit.
- What is the exiting co-founders’ contribution to the development of the business? Is there any IP involved?
In early-stage companies, intellectual property (IP) could be the main stock in trade and therefore it is essential to establish that the company is the owner of the IP. The presence of an employment agreement or founders’ agreement makes this process simpler, as they typically contain clauses on ownership and assignment of the IP in the favor of the company, by the founders. However, in the absence of a clear contractual assignment, it becomes essential during a separation event, to get all IP assigned in favor of the company.
- Is the exiting co-founder also a director in the Company?
If the exiting co-founder is a member of the board of directors of a company also, the separation terms should address the issue of his/her resignation and filing of such resignation within 30 days with the registrar of companies having jurisdiction. The continuing founder shall ensure that there continues to be at least 2 (two) shareholders and 2 (two) directors in the company, even after the separation, in compliance with the provisions of the Companies Act, 2013.
- Taking stock of liabilities and indemnities:
During separation, it is important to take note of the stock in trade, books of accounts, statutory and contractual dues, pending litigations, indemnification obligations under any existing agreements and other financials of the Company. The exiting co-founder may be held liable for any and all statutory and contractual dues, especially for any defaults of the company during his/her tenure of association with the company. In instances such as fraud, wilful misrepresentation etc. the exiting co-founder may also be held personally liable for any damage, loss caused to the company (any existing shareholders’ agreement must also be evaluated in this regard).
- Other Considerations:-
In addition to above, the other material issues for consideration could be:-
- Non-disparagement: This obligation is generally mutual in nature. Instances of disparagement may lead to bad name and reputation of all parties involved in the separation.
- Non-compete, non-solicit: Typically, these flow from employment agreements/founders’ agreement, if executed.
- Confidentiality: The exiting co-founder should be contractually restricted from disclosing any confidential information obtained by such co-founder during the course of his/her association with the Company. Any such disclosure of confidential information may lead to irreparable harm to the business of the Company.
- Branding: The exiting co-founder post such exit, should not brand himself/herself as being associated with the company. The company should always intimate other parties working with the company and revise (to the extent practicable) all agreement, commercials, vender contracts and any other such document where the exiting co-founder has been a party in his capacity as a founder.
- If an exiting co-founder retains equity in the company, post-exit;
- the duration of non-compete, non-solicit in some instances should be linked to shareholding in the Company.
- there should be a power of attorney in favor of one or more of the continuing founders, for ease of operational matters.
- there should be transfer restrictions and provisions for treatment of equity (especially in case of an exit event for the company or a drag situation).
Each separation is unique in its own way and the dynamics vary depending on the relationship between the parties, many times they are just friends, family or ex-colleagues. Arriving and implementing the separation terms is a tricky affair that most importantly requires a neutral perspective and there have been various situations where mediation have come handy to resolve complex situations. To know more about mediation, you may see our posts available here.
 Please note that this post is a marker of reference points, only. Each separation requires customized advice and readers are requested to kindly seek professional advice in this regard.
Authors: Ms. Ayushi Singh, associate at NovoJuris Legal and Ms. Sohini Mandal, Junior Partner at NovoJuris Legal.