Lawyers hear the same horror stories all the time.
A client starts a company 50/50 with a good friend or business associate and one of two things inevitably happens. The new venture is either successful or within the first few years it struggles to generate revenue and falls apart. More often than not its the latter.
Even successful companies go through tough times (whether financial or otherwise) at some point. The harsh reality is that regardless of whether you are successful or not, co-founders often find themselves is disputes about how the company should be managed, or ownership stakes. While most start-ups are too busy focusing on building great products and services and conducting business development, they forget to run (or learn how to run) their company when it comes to financial and legal requirements.
Management issues which often raise difficult issues for c0-founders include things like:
- the hiring and firing of employees;
- purchasing equipment and major assets;
- signing cheques;
- whether to pay dividends (profits) out of the company or reinvest them into the company for growth;
- raising outside investment or offering shares to employees;
- amending the corporate documents (articles of incorporation, by-laws etc.); and
- selecting what corporate opportunities to pursue.
The start-ups who paper a shareholder agreement and agree on how to manage these issues upfront are the ones best prepared to stage-off future disputes, and as a result, best positioned to succeed. On the flip side, I’ve seen disputes on management and shareholdings bring companies to a halt.
Aside from management issues, both unsuccessful and successful companies often face a number of potential disputes on their paths to growing revenue.
Common Disputes for Struggling Companies
If your startup is not an overnight success (few are), or if you struggle out of the gate, here are some common scenarios to watch out for:
- One founder needs to pay the bills and takes a full-time (or part-time) job somewhere while the other becomes disgruntled that his or her partner says he is keeping 50% of the company;
- You face tough calls on cutting costs and you disagree on the direction of the company with your co-founder. With no clear agreement on management, there is a fight over whose direction prevails; and
- The founders can’t decided on issuing new shares and bringing new investors onboard.
Common Disputes for Successful Companies
If you do have some success out of the gate, a different category of disputes become more common. For example:
- A co-founder may want to sell his or her shares but there is no agreement in place on who they can be sold to and on what terms. In which case, you risk allowing your business partner to make anyone else an owner/partner;
- A co-founder may try to pursue business opportunities with clients outside the company where there is no agreement in place on competing with the business or whether opportunities must be pursued within the framework of the company;
- A co-founder may leave and take customers with him or her;
- If there is no agreement in place for deciding how or whether profits should be reinvested or paid out as dividends to the shareholders, co-founders risk a dispute;
- Where there is no shareholders agreement, minority shareholders may object to management or the founders increasing their salaries if the company becomes profitable;
- Where there is no agreement on who hires new staff, a co-founder may try to hire his friends or family to join the company.
- Where a c0-founder stops showing up for work they may still expect a pay cheque and dividends; and
- Where a co-founder passes away or gets divorced his or her shares may be transferred to the spouse who now owns half of your business.
These situations are only compounded if you have 3 or more founders.
The Shareholder Agreement
Some founders try to wait until the businesses is already generating revenue to arrive at a shareholders’ agreement to address management issues and shareholders rights. The problem, however, is that its much harder to agree on how these issues will be dealt with after they arise.
There are simple ways to protect the business and the shareholders from these types of disputes including shareholder agreements, different classes of shares and simple vesting schemes for shares in which shares are issued to co-founders at different milestones throughout the company’s history.