Knowledge Partners

 Economic Laws Practice       Avalon Consulting

 Technloogy Holdings   

August 27, 2016

Co-founder Quitting? Do you have these Protective Clauses?

"(Ashok) Arora, a B-Tech from IIT-Bombay (a colleague said he walked into the entrance exam unprepared and came out with flying colours), who wrote most of the critical programs for the company those days,  didn’t have the patience and sold his shares in the then unlisted company to the other co-founders for just Rs 25 lakh." - from a Business Standard article

Clearly, this was among the better managed and (in hindsight) most expensive co-founder exits that India has seen. Given that it had happened as far as back in 1989 - when forget templates for startup related processes existed, even startups were few and far between - the sum of Rs.25 Lakh for a struggling startup must have been a challenge for the other founders to generate.

According to Paul Graham, Founder of famed Silicon Valley-based accelerator Y Combinator, fights between founders are one of The 18 mistakes that KILL Startups. He further states that about 20% of the startups YC has funded have had a founder leave.

If companies of the caliber of Infosys and those backed by Y Combinator, face such serious challenges owing to a co-founder pulling out, how can other startups be prepared for such an event Ajay Jindal of Wisdomsmith Advisors advises (in a Businessline column) companies to insert protective clauses into the Shareholder Agreement (SHA) like:
1.  ‘All promoters, who are signatory to the SHA, shall devote their full time and attention to the company’. This means a promoter cannot do two ventures, or cannot walk out of a venture.
2.  ‘Promoters will not have the right to resign or leave the company without written permission of the investor’
3. ‘If a promoter does not wish to continue working full-time with the Company, such promoter will be required to sell all of its shareholding in the Company at minimum 75% discount to the price at which shares were issued in the round of funding immediately prior to such required sale. Investor and the remaining promoters will be entitled to purchase such shares on a pro-rata basis from such non-committed promoter’. 
What clauses should investors have?
1. Investor & Co-founders should acquire pro-rata the stake of the exiting founder. (The author believes this is not as draconian as investors reserving the right to acquire shareholding of all promoters at par, if any one promoter exits.)
2. Insist on a clause whereby any exiting or non-committed promoter should cease to be a director of company immediately (even though their shareholding may continue). 
3. In case the exiting promoter was vital to the business, then the investor may consider invoking material breach to allow the investor to force a sale of the company.
4. Having a Non-Compete Clause including barring the leaving promoter from hiring employees of the company. The time period for this is typically 3 years and can be upto 5 years as well.
5. Another small clause to prevent an indirect exit of promoter(s) is to bar them from pledging their shares to any third party, without written permission of the investor.
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