By Matt Crowley Matt Crowley As we discussed last month, having partners help you carry the load in starting your new business can be extremely valuable. If you have done your homework on your partners, you can be relatively sure that you can build a great team. But what happens if you guessed wrong and your partner is a disaster? A serial entrepreneur — someone who has started, run and sold several businesses — would tell you that if you had a shareholder agreement you could safely remove your problem partner without killing your business. A shareholder agreement is a document that covers how the shareholders will deal with basic scenarios where a partner is going to leave the company, either voluntarily or involuntarily. Sometimes these agreements are also called “buy-sell” agreements. This column will describe some of the key elements of a good shareholder agreement. Repurchase Rights The easiest points to deal with in a shareholder agreement are a partner’s death, retirement or resignation. Typically, a good agreement will give the company the ability to repurchase the withdrawing partner’s equity in the business. A repurchase right will use a formula to decide how much the partner’s equity is worth. There are many variants on the formula used, but typically, book value established by the company’s accountant is the cheapest, most efficient way to set the repurchase amount until the company actually starts making money. When a company becomes profitable, I usually recommend that a company avoid using complicated formulas to value the company, and just replace the book value mechanism with a provision calling for the hiring of an independent valuation firm. The danger in using formulas is the formula you pick to use in 2010 may create an awful result in 2011, depending on changes in accounting, the state of the business and the shareholders’ individual financial situations. Also, given that the company is now profitable, there will be money to pay for the valuation. Many repurchase arrangements allow a company to pay the repurchase amount over time to avoid gutting the company’s bank account on the day of the repurchase. Sometimes installment payments are coupled with interest if the payments need to be stretched over a particularly long period. As a final note on repurchase rights, frequently shareholder agreements will set up exceptions where the company is not allowed to repurchase the partner’s equity if the partner’s family inherits the equity and also agrees to be subject to the same repurchase right down the road. Right of First Offer Craig Newmark, the founder of Craigslist, ran into a bit of a nightmare scenario regarding sales of equity by his employees. Newmark was very proud that his website business wasn’t run as a cut-throat dot.com focused solely on profits. Consequently, he decided to share his equity with his small team of employees. From the news accounts, he didn’t put in any protections against sales to third parties. One day he woke up to headlines that one of his employees had sold his 25% interest to . . . eBay. The barbarians had breached the castle wall and were now inside his company. Yikes. Newmark could have avoided this scenario if he had made his co-equity holders sign an agreement allowing him, or Craigslist, the right to buy another equity holder’s stake before it could be sold to a third party. This right is called a right of first offer. The right would work this way: Sally gets equity in Startup.com only after she signs a shareholder agreement with the right of first offer contained in it. Sally decides a year later she needs cash for a new mansion. She decides to part with her 10 percent interest in Startup.com. Before she offers the 10 percent interest to anybody, she has to offer it to her partners, or Startup.com itself, first. Sally offers the interest to the partners or her company at a price set by the shareholder agreement. Newmark could have enjoyed his morning newspaper and coffee much better with such a right in place. Right of First Refusal Setting a formula in a right of first offer can make entrepreneurs anxious. These entrepreneurs will go with a more basic mechanism, called a right of first refusal. Under this strategy, a selling shareholder can offer her equity to a third party, but she can’t sell it to the other person until she gives the company or the other shareholders a chance to buy her equity at the same price and on the same terms as the third party. This method theoretically allows the outside world to set the fair price for the seller’s equity instead of trusting an accountant or investment banker to do it right. As you contemplate building your own startup with partners, consider these options and spare yourself a bad breakup. Matt Crowley is a veteran venture lawyer who has participated in over $6 billion in deals. He was also on the frontlines during the first dot.com era as a start-up general counsel. He is a member of the L.A. Venture Association’s executive committee and a graduate of the 2010 Leadership L.A. program. He can be reached at: [email protected]
How Startups Can Avoid the Pitfalls of a Bad Breakup
