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Incorporation Builds Business Relationships Among Founders

ncorporation is usually the first serious legal step in the life of a startup technology company. A well-organized corporation will embody the business relationship among the founders and other key players, and set enforceable rules and expectations that will carry the company forward.

For tech-based startups, even the most basic incorporation usually creates a significant change in the founders’ relationships. Before incorporation, they may be working as a team, but ownership of the technology may not be shared among them. If some but not all founders have developed the technology, they own it, not the whole team. Investors almost always require that the founders transfer ownership to the company.

Since the company is owned by all the founders (and investors), those who contributed the technology now are sharing ownership with all of the others who own stock. This is an irrevocable act; if the company doesn’t succeed, the founder who provided the technology can’t take it back and start again. Outside investors and creditors of the company may have first call on the technology.

There are alternatives to an outright transfer that can have an effect on the allocation of ownership and on the contributing founder’s future rights. A corporation at the startup stage is embodied in three legal documents:

 

  1. The charter is filed with the state of incorporation and sets the core legal framework of the company. It should include the capital structure, terms of the company’s stock and relative rights of stockholders, and indemnification protection for directors and officers.

    As investors contribute money to the company, they typically receive preferred stock, which gives them special rights. Many of these rights are implemented in provisions in the charter.

  2. The by-laws establish more specific rules for governing the company. They typically cover issues such as how stockholder and board meetings are called, how directors and officers are appointed and removed, and the scope of their authority, and thus have a significant effect on who controls the company’s operations. The by-laws must be consistent with state law.
  3. The stockholders agreement is a private agreement among some or all of the stockholders. It is highly flexible in terms of the subjects it can deal with and the ability of the parties to change it.

Issues typically covered in a stockholders agreement include:

 

  • Who will be the officers and the directors of the company
     
  • How voting control is allocated
     
  • Resolving disputes. This is particularly important when the board is composed solely of a limited number of founders and has the potential to become deadlocked. A common method is “Russian roulette,” where either side to the dispute can make an offer to buy out the other side. The other side must either accept the offer, or match it; if it matches the offer, then the side that started the process is the one that must sell. Other methods include appointing a neutral, tie-breaking director, and mediation or arbitration.
     
  • Fulfilling expectations. The normal assumption is that the founder will be actively involved for a period of time, most likely measured in years. This aspect of the business deal among the founders is typically implemented through stock vesting arrangements.

    The company has the right to buy back the founder’s stock at a nominal price when the founder leaves. The amount that the company can buy back at the nominal price declines over a period of years. However, the company often retains the right to buy back the rest of the stock at its fair market value to ensure that the only stockholders among the founding group are those who are active in the company.

     

  • Keeping it in the family.Startup companies should limit the ability of founders and other principal stockholders to transfer stock to outsiders. An underlying assumption is that the founders will be sharing control with one another, not unknown parties. Thus, in the stockholders agreement or some other contractual document, the founders’ right to transfer stock to others is typically limited.

    Since stock in a startup usually is not easy to market, the biggest concern for the company should be that of a forced transfer — either the death of a founder resulting in a transfer of the stock to the heirs, or a divorce that puts the stock in the control of an ex-spouse. Contract requirements that give the company the right to repurchase the stock in these situations will give control over these events.

     

  • Take me along or I’ll take you. When the opportunity comes to cash out of a privately held company, the buyer may be satisfied with obtaining a controlling interest but not full ownership. Conversely, the buyer may be interested in only obtaining 100 percent ownership. These scenarios can be covered in the stockholders agreement with so-called “come along” provisions, where the holder of a large block of stock can force the others to join in a sale, or “take me along” arrangements, by which the smaller stockholders can require that they be included in a sale by the major stockholders.
     
  • Multiple rounds of investments. Many companies go through multiple rounds of investments in their life cycle, and each round can involve extensive revisions to the arrangements discussed above.

The negotiations and resulting agreements can become complex, and the outcome depends on many factors — not the least of which is the urgency of the company’s need for new funds.