One of issues that the founders need to consider is the form of legal entity for operation of their new business venture (e.g., corporation, partnership or limited liability company); however, regardless of the form of entity selected the founders need to sit down and carefully discuss the relationship that will exist among the founders with respect to ownership and management of the business before outside investors are brought into the picture. When properly done, the ownership structure will protect the rights of each founder while creating incentives to make the business grow well into the future. The structure should always be flexible enough to adapt to future changes, including new employees and capital-raising from outside investors. Among the questions that need to be asked are the following:
- What percentage of the company will be owned by each founder?
- What rights will each of the founders have with respect to the management and control of the company?
- What tangible contributions (e.g., money, property, contract rights, etc.) will each founder make to the company and how will they be valued?
- How much time will each founder be expected to devote to the business?
- What incentives will be used to motivate each of the founders to remain actively involved with the business of the company?
- What procedures should be followed when a founder dies, becomes disabled, reaches retirement age, or voluntarily leaves the company prior to retirement age?
- What procedures should be followed to expel a founder from the company?
- Are there other persons outside the founding group who are likely to become actively involved in the business of the company?
The founders may be more interested in spending time on developing their new products and services than on dealing with what can often be very difficult and divisive issues. However, if these questions are not addressed at the beginning of the venture, it is likely that trouble will erupt down the road.
Allocation of ownership interests
In general, ownership determines how profits from the business will be shared and management rights will be exercised. Each form of business entity can be adapted so that certain founders enjoy greater economic rights as opposed to voting rights and vice-versa. In dividing ownership, consideration should be given to all of the actual and potential contributions of the founders to the business. For example, the founders may ascribe value to any or all of the following: cash and property contributed by the founders at the time that the new business is launched, including the costs to the founders of acquiring or developing the property; the value of anticipated future contributions by the founders, including cash, property, services, business development assistance, and introductions to business partners; and the opportunity costs to the founders of launching the new business. Obviously, it is difficult to value several of these factors, particularly those which are speculative and depend on performance in the future. However, it is important for each founder to believe that his or her contributions have been fairly recognized. Professional advisors working with the founders of an emerging company will likely recommend that weight or credit should be given to discovery or conception of the ideas underlying the business; the time and effort expended in leading and managing efforts to promote those ideas; the level of financial and personal risk assumed in forming and launching the business; the amount of income foregone by forming the company and accepting a nominal or modest salary during the initial development period; the amount of effort spent in writing a formal business plan for the company; the specialized expertise contributed toward the development of new technology and/or products; and the background, training and experience that the founder expects to bring to crucial post-formation activities associated with the actual commercialization of the company’s technology or products.
In some cases, one of the founders of a new business may contribute intangible property and services while the other founders are providing the cash necessary to fund the development and marketing of the products based on the intangibles. Since the founders may reasonably differ as to the value to be placed on the contributions of the non-cash participant, counsel must proceed carefully to make sure that the assets are fairly valued. In that situation, counsel is faced with reconciling the following issues:
- What method(s) should be used to value the intangible property and services be valued for purposes of determining the relative equity ownership of the business?
- What obligations, if any, will be imposed on the parties to make additional capital contributions?
- Who will own the rights to trade secrets, patentable, or copyrightable information? Will the founder retain ownership and license them to the entity, or will the entity own all the rights?
- What obligations will be imposed on the “inventor” with respect to continued development of the intangible property?
- Who will own the rights to the intangible property in the event the company merges or dissolves?
Another issue to keep in mind is the possibility that the relative ownership interests of the founders will be diluted by future events, such as the need to grant an ownership interest to new managers, key employees, and one or more groups of outside investors. For example, a founding group looking for venture capital funding may discover that they will need to set aside 5%-10% of the equity for filling out the management team, 10%-20% of the equity for a pool of incentives for new employees, and 40%-60% of the equity for sale to the venture capitalists.
It is typical for the founders to enter into various agreements that impose restrictions on their ability to free transfer ownership interests in the business. First of all, vesting restrictions may be used to ensure that the founders remain with the company long enough to provide the anticipated value that was implicit in their ownership interest. If an owner should leave the company before an interest has vested, the company and/or the other owners would have the right to acquire the ownership interest on favorable terms (e.g., at cost payable in installments over a period of time). Once a founder’s rights in his or her ownership interest have vested, other restrictions would apply that limit the disbursement of control outside the original founder group while at the same time providing the founders with some opportunity to gain liquidity for their interests in the event they become dissociated with the company.
- A right of first refusal provides the company and/or the owners with the first opportunity to purchase ownership interests that the founder wishes to sell to a third party. Such a provision can prevent the sale of ownership interests to outsiders and generally will substantially limit the transferability of the interests.
- A buy-sell agreement restricts transfers of ownership interests by granting the company and/or the other owners the right to purchase the interest of an owner upon the occurrence of certain events, such as a proposed sale of the ownership interest to a third party, death or disability of the owner, termination of employment, bankruptcy, or divorce. Buy-sell agreements may also provide liquidity by requiring that the company and/or the other owners purchase the interest of the deceased or disabled owner. Procedures for determining the value of an interest upon any required purchase and sale will be included in the agreement.
- Co-sale agreements, which are often used when venture capitalists invest in the company, allow outside investors to sell their ownership interests at the same time that the founders sell their interests. A co-sale right often is coupled with a right of first refusal and thus allows the investors to choose between purchasing the founders’ interests or selling out on the same terms and conditions.
Management of the new business
Regardless of the consideration they provide for their ownership interests, the founders must consider potentially contentious matters relating to control of the business. For example, decisions must be made regarding the voting rights of each of the founders and their power to control membership of the board of directors or other management body. The key issues to be considered include the following:
- What voice will each founder have in the election of the members of the managing body, such as the board of directors?
- Who will be responsible for the day-to-day operations of the business (e.g., officers of the corporation)?
- What level of consensus among the founding group will be required for major transaction, such as sale or merger of the company, major debt financings, and issuances of securities?
- What are to be the terms of any employment agreements between the company and the founders, including the amount of salary and other benefits to be paid to owners who are to be active in the business?
- What procedures should be used to resolve any disputes among the members of the founding group?
- How are the members of the founding group going to participate in the profits generated by the business?
- What restrictions should be placed on the outside activities of the founder, as well as their ability to transfer their ownership interests in the company?
The founders will often turn to an attorney to assist them in considering these issues and documenting their decisions. Counsel needs to be aware that the negotiation and drafting of an owners’ agreement will often lead to conflicts of interest such that the attorney cannot represent the founders concurrently. Even if all sides are properly informed of potential conflicts and grant the appropriate waivers, counsel still walks a fine line since it may be impossible to anticipate all the conflicts that might ultimately arise in the future. Accordingly, the attorney should be ready to prepare some form of disclosure letter and obtain a waiver of potential conflicts from each of the founders. If the founders are unwilling to waive the conflicts, separate counsel should be retained.
The members of the founding group should enter into an agreement among themselves as to how the company will be operated. In the corporate context, such an agreement is generally referred to as a pre-incorporation or shareholders’ agreement. In the case of a partnership or an LLC, the matters are typically covered in a separate part of the partnership agreement or operating agreement, respectively. In some cases, the founders will address these issues before the entity is formed in some type of pre-formation agreement. This can be a useful exercise since it can give the founders a good idea of whether they will be able to live and work with each other before they incur the additional expense of actually forming the entity. Voting agreements are often used to establish procedures for making decisions regarding important matters relating to the business. In the case of a corporation, voting procedures may be laid out in a separate shareholders’ or voting agreement. Voting provisions for partnership and limited liability companies are set out in the partnership or operating agreement, respectively. The founders may elect to cover a variety of matters in the voting agreement, including the vote required to elect the managers of the company and approve fundamental changes in the business, including a sale of the company or its assets, significant borrowings, and admission of new owners. Transactions between the company and one of the owners may also be subject to special approval procedures. Whenever an owners’ agreement is implemented, an evidence of an ownership interest (e.g., a share certificate) should include a legend that notifies third parties of the existence of a restriction on the rights of the owners with respect to transfers or exercise of economic or control rights.
Some or all of the members of the founding group may also enter into employment agreements with the company that describe their duties and responsibilities with the company, the terms of compensation for their services and, perhaps most importantly, the rights and obligations of the company and the founder upon termination of the founder’s employment relationship with the company. Employment agreements are often valuable to founders who hold a minority ownership interest in the equity of the company who seek protection against the possibility that they will be discharged by some concerted action of the majority owners. In addition, however, employment agreements can serve a number of purposes beyond merely providing protection to minority owners and setting forth the terms of compensation. Employment agreements that contain noncompetition provisions serve to protect the other founder in the event that the employee-founder leaves the enterprise and attempts to start a competing business. The employment agreement also settles issues regarding the ownership and use of intellectual property rights acquired by the entity.
This post is part of the Sustainable Entrepreneurship Project’s extensive materials on Entrepreneurship.