Lifecycle of a tech startup series: Founder Fall Out

Having received investment from a VC in episode 14, KNow Wear Limited has been going from strength to strength and is now looking to expand and market the product overseas. For our founders, this will mean significant time commitments over the next few years as they carry out their expansion plan.

Chris has concerns about the business taking time away from his family and he is now looking for a less-demanding role. You, Chris and Sarah have an informal meeting to discuss Chris’ role in the business and the future of KNow Wear Limited.

Stepping down as a director/employee of the business

An old friend of Chris’ has reached out to offer him a role at a tech company, which would enable him to work more “traditional” working hours. You discuss the opportunity and consider whether there would be an alternative role for Chris at KNow Wear Limited which would allow him to stay. Unfortunately, you are unable to meet Chris’ demands and it becomes clearer that Chris will likely be leaving the business.

The investment agreement entered into at the last funding round, and the employment contracts which each of the founders entered into with the company in episode 8, impose a number of restrictive covenants on the founders, including a non-compete and non-solicitation restrictions, applying for a period after a founder ceases to be involved with KNow Wear Limited. You consider whether Chris would be in breach of the non-compete restrictions if he accepts the new job offer however, after discussing it with the company’s lawyers, you agree that he would not as the tech company Chris is proposing to work for is in a different sector, focusing on greentech and sustainability.

In episode 3, we discussed the importance of assigning intellectual property rights to ensure that the company owns the intellectual property rights in the business/product. Luckily, Chris has already signed a deed of assignment of intellectual property for intellectual property created before he became an employee of the company and his employment contract contains provisions confirming that any intellectual property created during the course of his employment would belong to KNow Wear Limited.

Impact on shares

Although your, Chris and Sarah’s shareholdings have been diluted by the previous funding rounds, each of you still retain a material shareholding in KNow Wear Limited. As Chris will be leaving the company, he will be subject to the leaver provisions and the reverse vesting mechanism proposed and subsequently agreed in episode 14. To recap, it was agreed that:

• a “good leaver”, being a founder who ceases to be an employee due to ill health, death, retirement or unfair dismissal or if the board agrees that the founder should be deemed a good leaver, will be required to offer up all of their shares for sale at fair value;
• a “bad leaver”, being a founder who ceases to be an employee due to being dismissed or a founder who breaches their restrictive covenants, will be required to offer up all of their shares for sale at the price paid for their shares; and
• an “intermediate leaver”, being a founder who ceases to be an employee for any reason and who is not a good leaver or a bad leaver, will be required to offer up all of their shares for sale, at fair value for any vested shares and at the price paid for any unvested shares.

Pursuant to the above definitions Chris should be treated as an intermediate leaver however he has asked to be considered a good leaver given his contributions to the company thus far and that the sole reason for him resigning is to be able to spend more time with his husband and young children. The board will need to consider his request and consider a number of factors when deciding whether Chris is to be considered a good leaver or whether he remains an intermediate leaver, including the number of shares Chris will be required to offer up for sale at fair value under each definition; and therefore the ability of the company and the other shareholders to fund the purchase of Chris’ shares.

In addition, Chris had transferred some of his shares in KNow Wear Limited pursuant to the permitted transfer provisions in the articles of association of the company, to his husband, Bradley. If Chris exits the business the leaver provisions will catch Bradley’s shares too because the company’s articles of association provide that, unless the board directs otherwise, the shares held by permitted transferees of a founder will also have to be offered up for sale if the founder ceases to be an employee.

The board have a lot of discussions about this and ultimately agree that, because Chris is leaving so soon after the company has received substantial investment from a VC, he should be treated as an intermediate leaver and the shares held by his permitted transferees should also be caught by the leaver provisions. The founders had agreed in the last funding round that the leaver provisions would only apply to a percentage of the founders shares and therefore you are comfortable that treating Chris as an intermediate leaver is fair because he will still receive fair value for some of his shares.  

You note that pursuant to the pre-emption rights on transfer, which are set out in the company’s articles of association, the company has a right of first refusal on the shares to be transferred.  However, the company does not have sufficient distributable reserves to buy Chris’ shares. Even if the company did have sufficient distributable reserves you are conscious about the effect a share buyback by the company could have on the SEIS and EIS relief claimed by the angel investors who invested in the company in episode 7; namely that a  buyback made within the 4-year period starting 12 months prior to the issue of SEIS and EIS shares could result in the loss of their relief for the investors.

As the company is not exercising its right to buy back the shares, pursuant to the pre-emption rights on transfer, Chris’ shares are then offered to the remaining shareholders pro-rata to their current shareholding. The angel investors choose not purchase their proportion of Chris’ shares as that could impact on their ability to claim EIS relief on future investments made into the company. However, the VC does choose to take up its pro rata entitlement. Both you and Sarah also choose to take up your pro rata entitlements as you do not want the proportion of shares which are held by the founders to be diluted to such an extent that it means the founders lose control of the company. Luckily both you and Sarah have some savings which you can use to fund the purchase.

Replacing Chris

Chris’s role as lead engineer is critical to the business and the board will have to find someone else to step into that role. There is a promising employee, Ava, who you and Sarah would look to promote to replace Chris.

As a start-up, KNow Wear Limited’s strength is in its potential future growth and so, to incentivise Ava to take up the promotion, the board would look to offer her shares in the company.

There is an existing share option scheme in place however, when the size of the option pool was agreed, the board had not considered that they would need to use options to incentivise someone new in such a key role in the business. Therefore, the board will need to consider if they need to increase the option pool.

The optics

The expertise and the drive of the founders were contributing factors to KNow Wear Limited successfully obtaining investment. Given Chris’ significant role in the company to date, the company’s investors may not be so keen to hear that he will be leaving the business and any announcement of Chris’ departure will need to be handled carefully.

A co-founder leaving a start-up can create turmoil and substantially change the dynamics of the business. You, Chris and Sarah will need to consider how Chris’ departure will be communicated to the rest of the board, the employees of the company and to the company’s investors.

Maintaining open communication with the board, the investors and the rest of the team will help to build trust and confidence and can help to ensure a smooth departure and transition. The board will need to devise a communication strategy and a plan for Ava to step up to replace Chris taking into account the company’s wider expansion plans.

Chris is keen to cause as little disruption as possible and agrees to support any communication plan prepared by the board.

You and Sarah, although sad about Chris’ departure, wish him all the best – whilst you may no longer be seeing him around the office, you’ll be sure to bump into him at the local pub! You also remain excited for the future of KNow Wear Limited and already have some existing meetings in the diary about new routes for marketing the product overseas. 

ABOUT THE AUTHOR

Mei Chung is an Associate in the Corporate, Commercial and Finance team. She advises entrepreneurs, investors, startups and established businesses across a variety of sectors on a broad range of corporate and commercial matters.