We discussed earlier in the Bench to Market series the selection and formation of the legal entity that will own the technology and carry on the business of the founders. In connection with this formation and prior to engaging with investors, contractors, and others, the founders of the new business should establish clearly the terms of the venture as between themselves. They need to consider carefully and come to agreement on the ownership, management, and other important aspects of the business. Ultimately, through their discussions and with the aid of an attorney, the founders should have a set of legal documents that completes the formation of the entity, reflects clearly and with precision the terms of the venture, and prepares them to operate the business in the market without disruption. Below is a summary of key terms of the venture arrangements that the founders of any new business should establish with each other.1
The founders need to make the threshold determination of who owns the legal entity and in what percentages. If the entity is a corporation, this determination will dictate the allocation of profits and control of the business. If the entity is a limited liability company, the founders will have the freedom to set up procedures for control that need not reflect the ownership percentages. Ownership percentages typically are derived from the value of the respective assets contributed by the founders to the business. This value is easily determined when the founders contribute cash; however, a founder may contribute intellectual property, services, or other intangible assets, and in those cases valuation becomes more difficult and potentially contentious. If a founder receives an ownership interest in exchange for services (i.e., “sweat equity”), it may be appropriate to condition the ownership on the satisfactory completion of those services.
Ownership interests issued to the founders usually will be of the same class or type, such as common stock if the entity is a corporation. The founders may, however, create different classes of interest to provide for various rights and preferences as between themselves. For example, one of the founders may receive a “preferred” interest, which entitles him or her to priority in the distribution of profits from the venture.
The founders also should consider whether to create an equity compensation plan, through which the company may grant ownership interests to employees, contractors, and even the founders themselves in order to establish incentives for the performance of services to the company. Important considerations include: (i) the percentage of the company’s ownership allocated to the plan; (ii) the types of equity granted under the plan, such as options, restricted stock or “phantom” shares; and (iii) the conditions to vesting of rights to the equity, such as length of service or achievement of performance milestones.
Management and Governance
The founders must also decide who will be responsible for and have authority over management of the business as well as the structure of the management arrangements. While governance structures vary depending on the type of legal entity, this normally requires the designation of the following in the case of a corporate entity: (i) a board of directors (or managers in the case of a limited liability company), which oversees the affairs of the business; and (ii) officers (e.g., a chief executive officer), who manage the day-to-day operations of the business. Often the founders themselves fill these roles at the onset of the venture, as the founders’ need for and ability to pay qualified outsiders persons may be limited. The respective rights and duties of directors and officers should be carefully defined, including the terms of their authority, meeting dates and protocols, and removal arrangements.
In most businesses, the owners themselves, acting in their capacity as shareholders or limited liability company members, will reserve to themselves certain important decisions and delegate to the directors or managers other decisions. In a corporate structure, for example, the officers typically have authority to take routine, everyday actions on behalf of the business while the board of directors must vote on more significant, non-routine decisions; the owners would reserve to themselves the most significant decisions, such as a potential sale of the business. It is thus important for the founders to determine exactly what vote is needed by the owners to take an important action. A simple majority of the applicable voting group is normally authorized to take most actions; however, it may be appropriate in many situations to require a greater vote or to give the minority owners a veto over certain actions.
When starting a venture, the founders, who know each other well, voluntarily choose to associate with each other. Thus, to prevent being compelled to carry on the venture with other persons, the founders should consider whether to restrict each other’s ability to transfer their ownership interests. For example, a founder may be prohibited from transferring his or her interest without the consent of the other founders subject to certain qualifications. Alternatively, the other founders may have a right of first refusal in connection with any proposed transfer, i.e., a right to purchase the interest on the same terms and conditions offered to the potential buyer or on other terms that are agreed upfront.
Of course, for many founders, the ultimate goal of the venture is an “exit event,” such as a sale of the business to an established company or an initial public offering. While an exit event may seem only a distant hope at the onset of the venture, the founders would be prudent to consider and determine at the start such important issues as who can decide when an exit event occurs and upon what terms and conditions. This foresight should enable the founders to minimize disputes as the business grows and to increase the likelihood that they will realize their long-term expectations.
Most exit events will require the approval of the directors and owners, and as set forth above, the founders should be clear as to what vote is required. Also, the founders should consider providing for drag-along rights, which facilitate a sale of the company by entitling the majority owner to require the minority owners to sell their interests on the same terms and conditions as the majority owner, and tag-along rights, which protect the minority owner by entitling the minority owner to sell his or her interest on the same terms and conditions as the majority owner.
1When there is only one founder, most of this discussion is not applicable, as all ownership and control of the venture will typically belong to that person. Many of the issues presented will apply, however, if and when a sole founder desires to bring another person into the venture.