Personal Finance

Don’t let start-up founders flee

Ajay Jindal | Updated on January 17, 2018 Published on August 21, 2016

Inserting clauses into shareholder agreement should do the needful

Startups are stressful places. Founders start with a lot of enthusiasm, but sustaining the hard grind over several quarters, sometimes years, is not an easy task. Consider this in light of the situation that, often, there is hardly any financial reward early on. Promoters may not be able to take home any salary at all, and would more likely be cash negative; in other words, investing more than they anticipated before they started out.

Raising an angel fund does reduce the cash burden on the investors, and should ideally allow them to budget in a basic salary. However, it all still remains very frugal, till atleast a reasonable Series A (initial) funding gets raised. Most ventures struggle to raise Series A, or it may come later than budgeted.

That’s simply the stress from fund constraints. Actual conflict in founder relationships can occur as well, due to divergence of views, or if there is difference in value people are bringing to the company.

The problem areas

In short, founders do walk away, often in a huff. Like in a marriage, rarely is a founder parting amicable. For the company’s business, it is not necessarily a bad event. Quite likely a founder exit is actually good for the business: it is mostly the disgruntled founder that walks away. This frees the remaining founders to pursue their plans better. However, reverse may also occur. Sometimes the impact could be significant if the exiting founder tries to actively take away your business.

Besides the direct impact on business, the other concern area is the impact on future funding from the shareholding of the exiting founder. Let’s assume there are 3 founders, each of whom will have 25% holding after a dilution of 25%. A passive shareholder with 25% equity, and who is not adding any continuing value to the business, is a significant put off for a new investor. The continuing promoters will get left with less stake, despite adding all the future value.

Investors need to have all these concerns covered. The tool you have at your disposal is the Share Holder’s Agreement (SHA).

Protective clauses

The basic tenet of the SHA is to bind the promoter to the company till such external investors are present in the company. One normal clause typically says – ‘All promoters, who are signatory to the SHA, shall devote their full time and attention to the company’. This means a promoter cannot do two ventures, or cannot walk out of a venture.

As added protection, some agreements have a clause which states – ‘Promoters will not have the right to resign or leave the company without written permission of the investor’.

If a promoter does really want to exit, then there are clauses to enable continuing shareholders to acquire her shareholding. A sample clause goes like this: ‘If a promoter does not wish to continue working full-time with the Company, such promoter will be required to sell all of its shareholding in the Company at minimum 75% discount to the price at which shares were issued in the round of funding immediately prior to such required sale. Investor and the remaining promoters will be entitled to purchase such shares on a pro-rata basis from such non-committed promoter’.

This an important clause, which should be inserted in an SHA, and should be exercised. This will enable continuing promoters to hike their stake, and increase their commitment to the company.

We have seen a case where the investor reserved the right to acquire shareholding of all promoters at par, if any one promoter exits. This appears quite draconian; everyone acquiring pro-rate makes more sense.

The investor should also insist on a clause whereby any exiting or non-committed promoter should cease to be a director of company immediately (even though their shareholding may continue).

In case the exiting promoter was vital to the business, then the investor may consider invoking material breach. The clauses above do leave the door open for that. A material breach, which may need to be proven in arbitration, can allow the investor to force a sale of the company. While this is not a great outcome, it can help investor salvage some value from the investment, and all parties can move on.

In case an exit is given, the way to take care of any active business impact is very straightforward: non-compete clause. In various forms, this is also there in employment contracts at senior levels. Essentially this stipulates that a promoter, if she/he leaves a company, cannot start or join something which is in the same business area as the investee company. Also, at the same time they cannot hire employees of your venture. The time period for this is typically 3 years and can be upto 5 years as well.

Another small clause to prevent an indirect exit of promoter(s) is to bar them from pledging their shares to any third party, without written permission of the investor.

The writer is a partner at Wisdomsmith Advisors LLP, which also runs an angel platform Wisdom Angels

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