Prepared by Andrew B. Coburn
As seen in Business Black Box
Q1 2015 Edition
All too often as a corporate lawyer, I come across startup companies that have issued stock to their founders without any restrictions or conditions. This is a recipe for disaster. If disaster occurs, it usually looks something like this: Two founders form a company and issue fifty percent of the stock to each founder. Their initial contributions to the company are a business plan and their personal expertise and labor. The company starts to become successful, but one of the founders turns out to be lazy, corrupt, incompetent or alcoholic. That founder leaves the company or is terminated, owning half the stock. The stock was not subject to vesting or buy back rights, so the other founder has no way to get it back except through a negotiated purchase, assuming that their former business partner is willing to sell at a price that the remaining founder is both willing and able to pay. All too often, the departed founder holds the remaining founder up for an unreasonably high price. The remaining founder faces the miserable choice of either paying ransom to get the stock back or building the business knowing that half of the value they create will benefit their no-good former business partner.
The primary tools to avoid such a disaster are vesting and buy back rights. The types of vesting that may be used are the same types used in stock plans. In general, stock may become vested over a specified period of time based on the founder’s continued service with the company and/or the achievement of specified performance goals. If the founder ceases to work for the company, any stock that has not vested generally is forfeited. Buy back rights typically give the company the right to repurchase the founder’s stock if the founder stops working for the company, usually at a nominal or low price. If the founder remains employed by the company, the repurchase price usually adjusts after several years to fair market value of the stock at the time it is repurchased, except in cases where the founder is terminated for bad conduct.
In general, the only time that founder’s stock should not be subject to vesting rights is if the founder purchases the stock in exchange for cash or valuable property. Valuable property for this purpose does not include intellectual property with a speculative value. Stock purchased with cash or property generally will still be subject to buy back rights, but the repurchase price would typically be the amount of the cash, or the value of the property, paid for the stock or full fair market value of the stock at the time the stock is repurchased.
The nightmares that can be caused by founder’s stock can be avoided, but it absolutely requires prior planning. Without proper preparations, you may end up at the mercy of your former business partner.