26 Jan 2021 by JC Legal

What happens if one of the co-founders of my startup leaves?

Founder fallouts are not uncommon for startups, especially when things don’t go smooth. It can happen to the best of friends. What really happens when one of your co-founders leaves depends on how prepared and how well thought out you are at the conception of your startup company. In short, a carefully devised vesting schedule and a clearly drafted founders’ agreement are the keys to minimising disruptions to your business in case a founder leaves.

Reverse vesting scheme and retention of shares

Reverse vesting is the process by which founders acquire full ownership of their shares over a specified period. During the period of reverse vesting (called a vesting schedule), if the founder leaves the company, the company has the right to forfeit the unvested shares; in other words, the founder will be obliged to sell his/her unvested shares to other existing shareholders or the company at a nominal price. Upon the completion of reverse vesting, each founder acquires full ownership of their portion of shares. A reverse vesting scheme incentivises and rewards founders who make long-term commitments as it ensures that founders do not acquire the full right to their shares right away. It discourages founders from leaving the company early on.

Reverse vesting schemes for startups typically span across three to four years, with a one-year cliff. This means that no shares are deemed to have been vested during the first year (the cliff), and 25% of his/her portion will be vested at the one-year mark. Over the next three years, his/her shares will be vested linearly (or monthly or quarterly) until he/she fully acquires his/her shares at the four-year mark. Below is an illustration of how a typical 4-year vesting schedule looks like:

Time lapsed after the shares are vested % of his/her shares acquired
0-1 year 0% (1-year cliff)
1 year 25%
1-4 years 25% to 100% linearly over time

Using the above example, we can see how a reverse vesting scheme helps protect remaining founders against a founder’s early exit. Suppose you launched a startup with another co-founder and each of you are allocated 50% of the company’s shares. You did not include a reverse vesting schedule in your founders’ agreement, meaning that each founder acquired full ownership of their shares right at the beginning. Your co-founder decides to leave within a year. Even though he is not involved in the company’s operations anymore, he would still own 50% of the shares and retain a 50% control over your company, unless you buy out his shares at market value. However, the limited contribution of the early-leaving founder may not be worth the full market value of his shares.

On the contrary, if there had been a four-year reverse vesting scheme in place (like the one illustrated above), your co-founder would not have acquired any shares during the one-year cliff. He would be disincentivised from leaving, and even if he does leave, the company can always forfeit the unvested shares without suffering any loss.

Under what circumstances could a founder be terminated?

Startups should clearly define the roles and responsibilities of each founder to avoid unnecessary disputes. Startups that put thought into founders’ responsibilities might also include provisions in their founders’ agreement stating that a founder who fails to fulfil his/her duties would have to leave the company and surrender his/her shares. A founder might also be terminated on grounds such as gross misconduct, gross negligence, breach of the shareholders’ agreement, fraud or other criminal convictions. A founders’ agreement might provide that founders terminated for serious causes are required to surrender their shares at a discount or even at a nominal value.

IP rights and competition

A carefully drafted founders’ agreement should prevent the situation where a founder leaves with your company’s intellectual property, or worse still, start a new business as a competitor with your startup’s creations. To make sure that this doesn’t happen, it should be provided that IP rights should be owned by the company only but not by any individual founder. This could also prevent a leaving founder from asserting any claims on creations or technologies that he/she helped develop.

A founders’ agreement also typically contains a non-compete clause. A non-compete clause normally stipulates that a departing founder must not join a competitor, start a new business in competition with the company or bring any of the company’s clients with him/her within a specified period.

A founder leaving is far from the end of the world, if you are prepared for the worst. Find a solicitor to help you devise a reverse vesting scheme that suits your business and to prepare a founders’ agreement that protects you, your co-founders and your startup.

This summary is for information purposes only. Its contents do not constitute legal advice and should not be regarded as a substitute for detailed advice in individual cases. Transmission of this information is not intended to create, and receipt does not constitute, a lawyer-client relationship between JC Legal and the user or browser. JC Legal is not responsible for any third-party content which can be accessed through the hyperlink provided in this summary.