These clauses are there to protect you as a founder from the event that someone on your team wants to do something else, as well as protect your investors.
I’ve talked to hundreds of startups. And believe me when I say that cofounders leaving the team is common. In fact, team-related problems might be the main reasons a startup fails in my opinion. But the good news is you can prepare yourself for how to handle this.
I want to make a disclaimer here. I’m not a lawyer, and certainly not your lawyer. This piece of content should be seen as entertainment and should not be considered to be legal advice.
With that said, here is a story based on a real-life case where a startup with a decent founders’ agreement ran into trouble anyway.
Table of Contents
Be careful when founding a startup without 100% dedication from all cofounders
Johanna, Carl, and Lisa are starting a business together. Their business idea is to create informational articles and videos for a common medical condition and put this into an app. They have a good team setup. Johanna is a medical doctor and Carl is too. And Lisa has a background in tech.
They sign a founders’ agreement. Johanna and Lisa have quit their jobs to focus 100% on their startup. Carl can’t, or won’t, do that. His expertise in this medical condition is crucial for creating trust in their product. Instead, he vows to spend all his free time to support their startup. They split the ownership of the startup 40% / 20% / 40% with Carl getting 20% since does not work full time with the startup.
In their founders’ agreement, they add a clause about reverse vesting exercised over 3 years. This means that if someone leaves their business in the coming 3 years, that person has to sell back a portion of their shares to the other cofounders for basically nothing. If you stayed for 1 year before leaving, you can keep 1/3 of the shares, staying 2 years leaves you with 2/3, and so on. You get the idea.
Everyone is excited. They will help a lot of people with this medical condition, they get to run their own company and they like working together. The sun is shining on the startup. Let’s go change the world!
Some cofounders might not be dedicated enough to make the startup a success
Fast forward 2 years. The team has just graduated from an incubator. And raised their first round of financing! €500k at a €2.5M pre-money valuation. The team has their shares diluted by 16%. Finally, the team can start taking some salary. The product is starting to shape up. They have an app out in beta since a year back and some content has been created. But not as much as they had hoped at this time.
But Carl seems to be a problem for the startup. At least Johanna and Lisa think so. He is in charge of content production as he is the medical expert. But when they talk to him there is always something stopping him from producing the content. His family has been sick, lots of things to do at his day job, and so on.
The investors are worried. And so is Johanna and Lisa. So they have a serious talk with him. Either you produce 10 pieces of content by next week or you are out. The week passes and once again Carl comes with excuses. Not one single piece of content is fully done. A few have been started but are nowhere good enough to put in the app.
It is hard to let a cofounder go without a good founders’ agreement
Carl has to go. Everyone agrees. Even Carl thinks he should not spend more time in the startup working on it operationally. In his mind, he will do more good giving advice and being the poster name since he is the medical expert on the condition.
All three sit down and talk about what to do with Carl’s shares. The team has always had a plan to go down the VC route. Raising an A-round in the millions of euros round size range. But they are nowhere near the traction needed for this. Who would have thought it would take several years to get to an A-round?
It becomes clear that Johanna and Lisa are not in agreement with Carl about what to do now. Carl wants to read the cofounder agreement literally. He is not even a “Bad Leaver” according to the contract since they didn’t put in any dedication clause. He says he will still support the startup with what he does best. He thinks he should keep his 16.8% (he got 16% dilution in the round), but not take any salary.
Lisa and Johanna are frustrated. Looking back they should have put down the foot earlier. Their investors tell them it will be tough raising their A-round down the line with Carl as a passive founder on the cap table owning 16.8% of the company. But Carl says he has done his best to get them where they are right now.
But what does the cofounder agreement say?
The reverse vesting clause should be 7 years in your founders’ agreement
The founders put a 3-year reverse vesting clause in their contract. And they have already been going for 2 years. There were 2 main reasons for putting 3 years in the contract. First of all, they didn’t think it would take this long to start a business. Maybe a little longer than 3 years, but they thought they would have enough customers by now to break even.
And secondly, everyone was thinking about it from their standpoint. What if I want to leave the startup? Dedicating 3 years of my life seemed enough to be entitled to my piece of the company. Never did they think about the reverse vesting clause as a means to protect themselves from their cofounders wanting to leave. And besides, cofounders leaving the team was not in their mind at all.
In the end, they finally agree. Johanna and Lisa dip into their savings and pay Carl €15k each for 5% each of his 16,8% at market value. Carl then keeps his 6,8% of the company.
Johanna and Lisa are tired after all this negotiation and conflict. It took most of their mental focus for 2 months. Nobody is really happy. This is not what they thought would happen when they started the company.
The future of the startup is unsure.
What founders do wrong when setting up their founders’ agreement
Building a company is a decade-long commitment. And changes in the core team are a common reason for startups to fail. It is just the nature of life that people’s priorities shift. Don’t try to try to fight it. Instead, plan for how to handle it when it happens.
Set up your founder’s agreement with a dedication clause ensuring your cofounders are 100% committed to building this business. Any writings about x amount of hours, or x % of a full time will be hard to enforce. It has more to do with skin in the game. If your fellow cofounders have no other employment you can rest assured they are as all in as you are in building the company.
If anything, be sure to add a reverse vesting clause with a 7-year time frame enabling you to buy out your cofounder and give that equity to other people you bring on board. And be prepared to recommit to a new vesting schedule down the line if investors ask for this as a condition to invest. All that matters is how much value you have managed to build in your startup, not how much time you spent.
It’s much better to have a conversation about commitment at the start of the journey instead of when the conflict already has started.
A final word
Founders often get defensive when I talk to them about reverse vesting. They seem to think I am trying to lock them up with these clauses. They are of course right to an extent. But the best setups are when it’s mutually beneficial.
Investors do not want key people to leave the team. Especially not before you have started scaling and have serious funding. But as a founder, you should have the exact same concern.
Founders who are not prepared to sign 100% dedication and a long vesting period are probably not committed enough to make a startup a success. I often avoid these cases, and you as a founder should avoid this type of cofounder too.
FAQ
What is the difference between reverse vesting and vesting in founders’ agreements?
Reverse vesting is the right, but not the obligation, to buy back shares that are already owned by another shareholder. This setup is common among cofounders.
Vesting is a setup where shares/options become available over a specific time. This setup is common when bringing on employees that the company wants to incentivize to stay with them for a longer period.
In both cases, the shares usually vest linearly over a specific period and often contain a cliff. The cliff is the first period in the timeframe that needs to be passed before any shares become available / can be kept. A cliff is used to protect the startup from ending up with many small shareholders on the cap table in case someone changes their mind early on a commitment.
What is an example of a dedication clause in founders’ agreements?
The key to this clause is to use the wording “entire” or 100% of their business time. If you start to go down the road of defining business time in hours per week, for example, “40 hours per week” it becomes a matter of interpretation. It is the commitment to focus on only this one startup that is important, not the amount of hours.
Here is a good example of what it can look like:
Each of Cofounder 1 and Cofounder 2 shall, as long as he/she is an employee of the Company, devote his/her entire business time and attention to the Company and not undertake additional business activities without a Founder Majority Consent.
Founder’s Agreement, Startup Tools
What is the meaning of a Bad Leaver and a Good Leaver in founders’ agreements?
Bad Leaver means you resign or make a material breach of the employment- or shareholder agreement.
If you are a Bad Leaver, you keep your already “vested” shares (so far earned shares) but have to sell the rest for quota value (basically nothing) if the other shareholders ask you to.
Good Leaver means you are fired without cause. Often you are also classified as a Good Leaver when you resign due to a death in the family or because of a serious illness.
As a Good Leaver, you also get to keep your already vested shares, but you can be asked to sell your unvested shares. The difference between being a Good Leaver and a Bad Leaver is that the other shareholders have to pay market value for your unvested shares if they want to buy them.
What is the difference between a shareholder agreement and a founder’s agreement?
A founder’s agreement is a type of shareholder agreement. You should write a founders’ agreement when you incorporate your company and start out.
Everything written in this article about founders’ agreements is 100% transferable to a shareholder agreement.
A shareholder agreement is an agreement between all shareholders. Founders and investors. A shareholder agreement will replace the founders’ agreement once you put one in place. It contains pretty much all the clauses and writings of the founders’ agreement. On top of that, it also regulates the investors’ rights and responsibilities.
You can choose to go straight for a shareholder agreement and skip the founders’ agreement.
