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Co-Founder Breakups: How to Handle Them

two people bumping fists; separation agreement
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https://therecursive.com/author/tytuscytowski/

Tytus Cytowski, is an entrepreneur, angel investor, and lawyer working with CEE startups. He has built a successful startup and technology law practice that has a focus on European startups expanding and fundraising in Silicon Valley.
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The journey of creating your startup can be unpredictable. Like a large percentage of relationships, partnerships between co-founders do not always work out.

Startup documentation should describe how to remove a founder. In many cases, though, founders only have preliminary or informal agreements, and they often do not agree on departure terms with anticipation.

When the company’s documentation is inadequate (or non-existent), negotiating the terms of exit and hiring a lawyer specializing in this field is even more necessary. In that regard, a Separation Agreement is the main tool to protect your startup. The separation agreement details several issues that may not be obvious to a non-lawyer. The obvious issues in the separation agreement are the termination of service, return of founder equity, and resignation from the startup by the departing founder. The agreement should specify the founder’s last day of service/consulting and ensure that all financial obligations of the firm end on the day of the founder’s departure. 

The Free Rider Issue 

The most common problem is the “free rider” problem. This term denotes the existence of shareholders who do not contribute to the growth of the company and who still have a substantial percentage of ownership in it. When proper paperwork exists this problem is solved through vesting. A “vesting schedule”, under which the founder obtains full ownership of his shares over a certain period, and according to a pre-agreed schedule between the parties. The most common example is monthly increments for four years. 

We will provide further clarification on vesting in a separate article.

Many times startups with VC investments will require a founder to give up more than his fully vested shares otherwise the company might become not investable in the future. For example, if an inactive founder has a significant amount of fully vested shares this can be a red flag for new investors. New investors do not want the company to be owned by inactive (departing) founders. 

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In this situation, very complex negotiations happen to renegotiate the equity position of the departing founder and restructure the company’s ownership structure.  We have seen VCs rescind term sheets once they discover founder disputes or inactive founders with huge equity positions. 

The termination of service and resignation should also be tied to a non-compete clause for an appropriate period of time if the applicable law allows for it. These types of provisions are widespread in employment relationships under United States law, for example. The scope of the non-competition clause should be consulted with a lawyer, as different jurisdictions contain different limitations in this respect. With non-US founders, the non-compete issue has to be double-checked with local counsel to make sure the non-compete is actually enforceable in the founder’s home country.

Parallel to the resignation from the company’s positions (management), the departing founder must waive any claims against the startup for future damages and liabilities. In return, the company must also waive any claims against the founder. In addition, the waiver must release the startup from all unknown future claims associated with the founder’s departure.

The Founder Departure Agreement 

The departing and the remaining founder must agree that they will refrain from making negative or unflattering statements in public or private about the remaining founders or the startup. This obligation includes tweets, blog posts or Facebook status updates. Non-disparagement clauses are often supplemented by a limited reference clause, which specifies what the parties may say about their relationship in the future. 

The founder departure agreement should also specify that the intellectual property belongs to the company. This is important when the founders failed to sign IP assignments in favor of the company when they started it. For example,  the company can be started as a Delaware LLC and the founders do not sign separate IP assignments and then convert the LLC to a Delaware C-corp without documenting the IP transfer from the founder. This leaves a gap in the IP flow to the company. In order to remedy this, the departing founder also waives any rights to the intellectual property and assigns any residual rights to the intellectual property to the company. Because many times the departing founder is based in Europe the US company may want to create a backup IP assignment based on local law (Bulgaria, Romania, Poland, Czech Republic).

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Regarding this point, it is crucial that founders sign a confidential information and invention assignment agreement with the company before they begin to work on the business. By signing these agreements forehand, you can potentially avoid a situation where your co-founder leaves, claims ownership of the startup’s intellectual property, and creates a competing company. 

Finally, founder departure can trigger also unfriendly immigration surprises for founders who are in the US on O-1 or L-1 visas. A founder has 60 days to leave the US from the moment he is terminated. This creates leverage for the company which wants to get rid of the founder and a problem for a founder who has been in Silicon Valley building a company. The departing founder has 60 days to secure a new visa to stay in the US. The departing founder would also need the cooperation of his old company in securing a new visa.

As outlined, the separation of a founder is a complex matter with many issues to consider. Separating from a co-founder is never an easy process, even if the circumstances are amicable. The last thing an emerging company needs is a messy or unpleasant founder separation. 

Therefore, departing founders should strive for a clean breakup with a win-win outcome, so that the company can recover from the loss of a key employee without having to worry about future legal issues.

 

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