‘Good Leaver – Bad Leaver arrangements’

Founder’s advice from a dispute resolution expert and a venture capital specialist.

Founding a company is a challenge, and so is keeping good co-founder relationships. In high-pressure environments as start-ups, good relations and intentions can quickly turn into contentious ones, that negatively impact the business and the growth of the company, or even lead to a failure of the venture.

Do not think that you and your partners are an exception. The quality of the relationship among co-founders is one of the most important elements of successful startups, and it will be tested thoroughly along the way. You will have highs and plenty of lows. You might run out of money. You will raise money. You might have to fire people, and you will hire people. All of that will raise the pressure.

Sometimes a founder will want to leave the company, sometimes the other founders will want a founder to exit due to issues on performance or infringements of mutual agreements.

All of that is normal and very common! It should not scare or discourage you, as thoughtful thinking through your partnership and structuring it well will keep you out of trouble.

We recommend implementing leaver arrangements so that the company, the founders and investors can rely on a legal framework to react to such issues, and make sure that a founder (partially) exits when his/her professional involvement ends.

Leaver arrangements are thus put in place to ensure there is an explicit link between the professional activity of a founder and his/her shareholding. If a founder leaves the startup, there should be an obligation to offer all or part of the shares to the other founders, in general on a pro rata basis to the remaining founders. Lots of issues arise in startups where founders omit to implement such leaver arrangements and are confronted with founders who cease to be professionally active but are not obliged to transfer their shares to the other founders.

Also, from the investor’s perspective, their investment only gives them a minority stake in the startup with certain rights and privileges. If all founders would terminate their professional relationship with the startup following the investment, the investor would be in a disastrous position. The company would be majority owned by founders who have ceased to be active in the startup, with no ability for the investor to actively control and run the startup itself or attract other persons to take over the company’s management.

Thus, as a principle, we advise to create a link between equity position and professional involvement.

In our view a fair manner of structuring Good Leaver — Bad Leaver arrangements takes into account the identity of the party terminating the professional relationship, the timing of such termination and the specific reason applied to such termination. Below we include what we consider to be a fair and balanced Good Leaver — Bad Leaver arrangement:

• Time commitment: the founders agree to dedicate their full professional attention for a period of three to four years to the start-up following the investment.
• Bad Leaver: is a founder whose professional relationship is terminated by the start-up for any of the following reasons: material and wilful breach of his obligations towards the company, fraud, deceit, embezzlement or any other serious criminal offence, gross negligence and any other act which would justify a dismissal for urgent cause.
• Early Leaver: we would typically restrict the early leaver event to a founder who voluntarily terminates his professional relationship with the start-up other than because of death or permanent disablement.
• Good Leaver: is a founder who does not fall within the Bad Leaver or Early Leaver definition, e.g. because of death, permanent disablement or upon termination by the start-up for reasons other than the Bad Leaver grounds of termination.
• Vesting: investors often insist on all shares held by founders to remain subject to leaver arrangements for an indefinite period of time. Consequently, the founders would at all times be obliged to offer all their shares for sale to the other shareholders upon termination of their professional relationship with the startup. From the founders’ perspective such arrangement is unfair as they will consider their shares to have been earned over the years. Therefore, the application of a vesting arrangement based on the time dedication is often agreed with only the unvested shares being subject to the leaver arrangements, with the exception of a Bad Leaver termination where all shares at all times remain subject to a call option. The vesting percentage can be freely determined but should be related to the time dedication agreed to, e.g.100% in the first year after the investment, 75% the second year, 50% the third year and 25% the fourth year.
• Beneficiaries: an investor will often argue that it should be entitled to purchase the shares of the leaving founder, while the founders often argue that they should be entitled to purchase the shares of the leaving founder with any remaining shares to be offered to the other shareholders. A typical compromise will consist of offering the shares of the leaving founders to all shareholders on a pro-rated basis.

These arrangements are very common, will benefit all stakeholders, and will allow you to keep your focus on the business as much as possible.

Natalie Lemense is a partner at Cresco where she often assists entrepreneurs and companies regarding shareholders’ disputes.

David Dessers is managing partner at Cresco and has extensive experience in structuring founders’ agreements.

Cresco’s founders’ agreements checklist is made available to all members of the GUILD! Register here for a free trial.

Applications for our next cohort of the GUILD Academy are open!