Part 1 of this post has to do with how we can protect ourselves—and our companies—from common, avoidable, legal issues. This entry is a continuation that gets into more depth, going through some specific examples.
Believe it or not, this is a common problem, and one you should be prepared for. Oftentimes, people with a legal interest (shares or stocks) in a company will leave their interest to their surviving family members in their will. If you have a corporation, that means that shares that give your business partner voting rights on major company decisions, will pass to their surviving family, who may or may not have any idea how to run your business. And you may not want to have to find out!
The easiest way to avoid this problem is to include a clause in your early agreements that lays out what will happens when anyone with a “voting interest” in the company dies or leaves the company for any other reason. It’s common to split stock types into 2 categories (also called different stock “classes”). One category will have voting rights and rights to profits, while the other will only get rights to profits. In this way, owners of the second type of stock will not be able to make voting decisions, but will still get the money benefit that was passed to them.
Still, splitting stocks into multiple classes creates its own problems. For one, it makes it more complicated for potential company-buyers to find and account for all the shares out there (they have to figure out how many of each type of share your company has, at what point each stock changed from a voting stock to a profits-only stock, who owns which ones and how many, how much are the profits-only stocks worth compared to the voting stocks, etc.)
People looking to buy your company will probably argue that the added complexity should lower the price value of your company overall, which means less money for you. This also may lower the value if you were to use your company to finance a loan through a bank.
An alternative to splitting stocks into various categories is to include a “forced buyout provision,” where you allow an exiting partner (leaving by choice or if they die) to force your company to buy the leaving member’s shares at a pre-specified rate, or the “fair market value.”
You can add a clause in your agreement that says that anyone with an interest in the company that wishes to leave or dies triggers a “forced buyout,” where the company buys that person’s interest back from them at whatever rate you think is appropriate. Startups often want to limit this to a percentage of profits for the previous year. But what if the company, in an effort to not have to pay out as much money, decided not to report any profits for the previous year? (they’d be trying to game your game company, clearly these people didn’t play the incentive-strategy game!).
You can avoid this by limiting the payout to gross profits rather than actual distributed (paid-out) profits. Either way, make sure that the provision doesn’t create too much incentive to leave the company. Obviously there’s some balancing that’s needed to write this clause to a level that everyone’s happy with, but at the end of the day, if you have a clear way for people to exit, you can spend your time working on your product, rather than feeling anxious about who might be leaving the company and what the fallout will be.
Are there any blog topics you’d like to see? Any legal questions you’d like answered? Please feel free to leave them in the comments section or shoot me an email. I’d be happy to help out.
– Jonathan Sparks, Esq.