The Pen's Protection: How Founders Cover Themselves in an Increasingly Complex Legal World

Key Takeaways

The legal world is complex, and there are a few large elements involving founder privileges, shareholders, the board of directors, and mergers and acquisitions (M&A) that all founders should think about.
Legal protection is do-or-die. Without the proper contracts, a founder may lose billions of dollars and possibly their entire company.
MACH37 has the resources and connections to help with the legal process.

Introduction

In 2005, Eduardo Saverin saw his share of Facebook dilute from 24% to 10%, but all other cofounders saw no change in percentage (1). While the movie, The Social Network, depicts this scene with exaggerated numbers, it captures the raw emotion that Saverin likely felt when he realized his percentage of the company had been illegally decreased (2, 3). Fortunately, Saverin was armed with “the Pen” (legal protection) and was able to settle out of court for a reported stake worth tens of billions of dollars (4). However, even though Saverin was able to recoup some of his financial loss, he lost the opportunity to be a part of building one of the farthest-reaching companies in the world.

This is the kind of story that can keep a founder up at night. We are living in a world of unimaginable complexity where a few words on a contract mean the difference between generational wealth and the unemployment line. Since startups are expected to move at breakneck speed, many founders may neglect their legal protection--a decision that could be fatal to their position and power. While this article is not meant to be a complete guide and does not substitute for a qualified lawyer, it may help to highlight important things a founder should be thinking about as their company takes off.

Founders

For a team of founders, there may be differing opinions on many elements of the business, but it is essential that the team agree on some fundamental aspects of their company’s operations (6). The following list includes some of the questions worth legally addressing between founders:

What role is each founder expected to take on? What will their position be? How will work be divided?
What percentage of the company will each founder get? Will every founder’s stock get diluted evenly at each funding round?
Does every founder have equal decision-making rights in the company? What is the required vote to override other founders? What is required if a founder should be removed from the company?
Are all of the founders on the board of directors? If not, then who is? How long will those people be on the board?
Does everyone have the right of first refusal? (More on this later.)

These questions can sometimes be uncomfortable to discuss, but addressing them early is better than doing so in a courtroom. These hard questions may also help to provide clearer direction and purpose for each contributing member of the founding team, thus improving the company and its vision.

Stock

Ownership of a company is fractionally divided into shares, or stock, in the company. After all, a founder may think they control their company but they only legally do if they have a certain ownership percentage or control of the board. Before a startup receives outside funding, its leadership should consider various forms of protection.

For instance, it is important to have all founders and investors sign a Shareholder’s Agreement (SHA). This contract dictates what can happen to each shareholder’s ownership in the event of a new investment or shift in ownership and can provide protection against vicious attacks concerning dilution and M&A. Additionally, an SHA can differ between people (one founder may have complete immunity from dilution while another may not). This is an important place for all parties to have lawyers involved to ensure fairness.

For any shareholder, a share dilution may occur if their SHA does not prohibit it. In short, a dilution means that a person’s percentage of company ownership decreases, something that could occur during new investment rounds. Dilution is not necessarily a bad thing--with new investments, someone will have to give up a percentage of the company to make room for the new people. However, it is important that all parties understand who that someone is. For some, a dilution of even a small percentage of a company can equate to billions of dollars and affect their legacy indefinitely.

Along with ensuring founders and investors are taken care of, a company could decide to have a vesting schedule that promises employees a certain amount of stock when certain goals or milestones are reached (6). These may include time at the company or more work-related accomplishments, such as the completion of a product or meeting a sales goal. Vesting schedules often attract important talent to startups where qualified employees accept a salary cut in exchange for the possibility of immense riches. This is a great motivation tool because it means each individual contributor has some ‘skin in the game,' that their work directly affects their net worth.

Merger & Acquisitions (M&A)

M&A is a large aspect of modern startup culture. Sometimes, being acquired is seen as the ultimate success for investors looking at short-term ROI. However, other times, shareholders may want to see how far the company will go. In order to protect the longevity of the company, certain clauses may be added to the SHA.

One such clause is the right of first refusal (RoFR). This gives a shareholder the right to accept or deny a selling offer from a fellow shareholder after the selling shareholder has received a third-party offer for its shares (9). This means that certain people can deny the sale of part of the company. This clause is usually enforced to keep the company together and ensure that majority ownership does not fall into the wrong hands.

Along a similar vein, an SHA may also feature the right of first offer (RoFO). This gives a buying shareholder the right to make an offer for a selling shareholder's shares before the selling shareholder can solicit third-party offers (9). This means that a current investor can increase their own stake rather than letting an outside body get part of the company. The RoFO is useful for keeping the company in the hands of a small number of people and can deter a hostile takeover.

On top of those two rights, there are two main clauses that an SHA can have that involve M&A: the tag-along and drag-along clauses (5). The tag-along clause states that any deal offered to a majority shareholder must also be offered to minority holders at that rate. This rule tends to look after ‘the little guys' and helps to keep minority holders relevant. If this clause doesn’t exist, then 49% of a company would be utterly irrelevant since a shareholder could control any company with a 51% stake. The drag-along clause seems to work in tandem with the tag-along clause, giving the majority shareholder the right to force minority holders to sell their part of the company. When the two clauses are used in tandem, they ensure that the majority shareholder still has the ability to sell ownership of the company and that all stakeholders get a slice of the cake.

Board of Directors

In 1985, Steve Jobs fell out of favor with the Apple board of directors and was forced out of his own company (8). This came after a dispute with the then-CEO, John Sculley, in which the board sided with Sculley’s opinion on internal matters. More recently, cofounder and CEO of Uber, Travis Kalanick, was ousted from the CEO position and stripped of most powers after a myriad of internal scandals and mounting concerns from employees (14, 15). These examples show why it is important that a founder has control of their board in stages of radical change.

They can accomplish that by holding more common board seats than the combination of investor and independent seats. Interestingly, a founder may not have to fill these common spots, so they can remain in control of the company indefinitely (7). During each new round of funding, investor seats may be added to the board, but common seats can also be added. As the company grows, investors will likely negotiate the common seat allocation to be lower, eventually taking control away from the founder.

Along with seat count, a board member may have special voting rights that give them a disproportionate amount of power relative to their ownership percentage (10). This can happen when different “classes” of shares are issued with different voting powers (11). For example, Mark Zuckerberg, Chairman and CEO at Meta, controls the majority of shares in the stock class with higher voting powers, causing him to still have control over the company (12, 13). Similar structures exist in other companies like Alphabet and Snap Inc., the parent entities of Google and Snapchat, respectively (12).

Looking beyond the confines of the legal world, a founder may try to retain ‘friendly’ board members when they are forced to add common seats (12). They could ask longtime business partners or friends to join the board who might be supportive of a founder’s vision. Asking loyal partners to invest also adds supportive investor seats to the board, further boosting the indirect power of the founder. However, this strategy is easy to spot so it may not be viable past a certain stage of growth.

Conclusion

The legal world is vast and its complexities innumerable. To save billions of dollars and precious time, a founder should be armed with working knowledge of the general legal requirements of starting a company. What other protection does a new company need? How should it get that protection? These kinds of questions are why MACH37 has a devoted accelerator program for early-stage companies that are developing cyber-related products and services. We target help for those who are ready to take their business to the next level and have the drive to do so. In our cohorts, startups can begin expanding their networks, exploring key business approaches, and learning legal intricacies that could save them from disaster. We encourage those interested to apply here to be part of the change that MACH37 represents.

Who Are We?

VentureScope works with creative entrepreneurs, venture capital investors, and large private and public sector organizations around the world that are trying to solve interesting problems. Our team has extensive and unique experience launching new business ventures, investing in promising startups, running startup accelerators, and providing strategic innovation and general management consulting services to large private and public sector organizations. We’re on the pulse of emerging and over-the-horizon technology and are tracking their growth and development against important industry problems to inform our deal flow and give you exceptional advice. MACH37 is our start-up accelerator designed to facilitate the creation of the next generation of cyber product companies.

References:

(1) https://www.businessinsider.com/how-mark-zuckerberg-booted-his-co-founder-out-of-the-company-2012-5#:~:text=On%20January%207%2C%202005%2C%20Zuckerberg,24%25%20to%20below%2010%25.

(2) https://www.imdb.com/title/tt1285016/

(3) https://www.youtube.com/watch?v=Kk1sjbNcCxI

(4) https://www.bloomberg.com/billionaires/profiles/eduardo-l-saverin/

(5) https://www.youtube.com/watch?v=fcjmVj5fM5k

(6) https://emergecounsel.com/law-and-business/protect-founders-stock/

(7) https://www.forbes.com/sites/timyoung/2019/06/23/maintaining-control-of-your-company-what-all-founders-should-know/?sh=6b357cea57a5

(8) https://www.businessinsider.com/steve-jobs-apple-fired-returned-2017-7#this-is-where-stories-differ-jobs-would-publicly-proclaim-he-was-fired-from-apple-after-that-incident-sculley-has-said-that-jobs-voluntarily-left-apple-after-a-showdown-over-the-price-of-the-macintosh-7

(9) https://www.hfw.com/Navigating-a-shareholders-agreement-ROFR-or-ROFO

(10) https://www.dlapiperaccelerate.com/knowledge/2017/should-founders-have-a-shareholders-agreements.html#:~:text=A%20shareholders%20agreement%20typically%20establishes,sign%20to%20purchase%20their%20shares.

(11) https://www.investopedia.com/terms/d/dualclassstock.asp