Co-founder shares in a breakup

What happens to the shares if a co-founder decides to leave?

What happens to a co-founder's shares in a breakup? I've previously written about how co-founder shares should be distributed among founders.

In the co-founder equity split piece from 2020, I wrote this:

"When a company starts, the co-founders will split 100% of shares between themselves. There are two types of co-founder equity splits. In a 'fair split'’ equity is divided equally among founders, such as 50/50 for two founders, 33/33/33 for three, 25/25/25/25 for four, and so on. An optional approach is that you have the unequal division of shares."

Whatever the setup, an inevitable early breakup might occur, where one of the co-founders leaves the company in the first few years of its existence. I have attempted to write this piece by looking at the breakup from all the perspectives: what you can do about it as a founder, what investors should know, and why this all matters.

First, why should you care

A co-founder who owns 15% of the company leaves. Big deal? Yes, it is a big deal, especially for an investor-backed company. 

Here's why:

Founder motivation. A co-founder leaving with a significant portion of the company may be interpreted as a lack of commitment to the startup's long-term success. The departure of a co-founder might create a domino effect, leading to the departure of other key employees if they know they won't be required to hand back their shares to the company.

Dead weight. Having previous founders on the cap table can negatively impact the startup's ability to attract further investment. VCs will look at the cap table and see dead weight there. If the shares are retained, they can be put to work by giving them to new hires. For the good of the company, you should ensure that the ownership structure remains aligned with the company's best interests.

As an investor, I've seen cap tables of companies over three years old, and often, there are these 10% to 20% that a co-founder who left still owns. And the existing founder is now less than 50%. If the company is doing phenomenally well, the alignment of controlling interests with the company's best interests may not be as critical. But often, the companies aren't doing well and need to raise more from new investors. 

Imagine this moment: wouldn't you rather part ways with the 10% to 20% ownership to a new investor who would bring much-needed capital to the company versus an ex-founder owning them and not contributing to the company's future?

Let's begin with how these unfortunate situations can be avoided.

Vesting and buyback

The shareholders' agreement governs the shares that the founder holds. I've previously shared my template for a shareholder's agreement (one that founders should do before investors join and then one that investors will help create for the company), and here are the key aspects that state what would happen to those shares in a breakup.

Vesting period. This is the period when founders don't fully own the shares in the company. Granted, the shares have been appointed to the founders, who are shareholders. However, the agreement restricts them from leaving the company and taking their shares with them. If the out-of-the-ordinary would happen and the company got sold in a few months, the vesting, in most cases, would be expedited, and the shares would be made available for the founder to sell to the buyer. Also, if voting needs to happen at a shareholder's meeting, the unvested shares would still be counted as voting shares in most cases.

Vesting is crucial in determining the fate of shares during co-founder breakups. Without vesting, the leftover founders and shareholders usually have no rights to these shares unless there's a buyback clause. 

A shareholder agreement can have a buyback clause instead of a vesting period, which enables the company or existing shareholders to buy back these shares at a fair market value or another defined value.

However, in the absence of a shareholders' agreement or if it lacks these protections, the departing co-founder may retain their shares.

Now, let's move to the second step after the co-founder's shares have been retrieved from the leaving co-founder.

What happens to the co-founder shares?

An automatic assumption for founders would be that the shares of the leaving co-founder would be distributed among the existing co-founders. But that might not be what the investors have in mind. Here are a few ways I've seen the leaving co-founder's shares getting distributed:

a) Existing co-founders gain control of these shares. This is common, especially in situations where the founders have been diluted to minority ownership of the company, and the shares will motivate the co-founders to keep pushing on.

b) For future hires, the shares are placed on the side, either stock options or pure stock. 

c) The shares are removed, and the number of shares in the company is deducted. This means that proportionately, the founders will own more of the company. Still, at the same time, the other shareholders, like investors and staff, will have a proportionately more significant ownership percentage of the company.

In venture capital-backed companies, investors might have something to say about how co-founder shares are distributed after a breakup. 

To avoid surprises and ugly founder/investor disputes, it's better to prepare now.

Prepare for a breakup.

Vesting is not the only part of the startup prenup that founders, investors, and shareholders should approve.

If you are at the start, you should include some principles for a situation where a co-founder leaves.

If you are raising money from an investor or have already raised, ask your investors how they believe a breakup should be handled. Ask them to clearly state how the shares will return to the company. What happens to these shares?

Founders and investors: get all of these in writing. Right now, before a breakup happens, I've been in a situation where one founder decided to leave and could have taken 20% because there was no shareholder's agreement, just a bunch of SAFE notes without any protection on founders leaving.

Final words

All the nuances of a breakup might be challenging to include in a shareholder's agreement because there are countless ways that the breakup can transpire. You must write them out and create a separate document communicating how the situation will be handled.

Do not sidestep this one. Everything is fine and rosy initially, but a few years later, you will thank me.

(Photo by Kelly Sikkema on Unsplash)