When Co-Founders Go to War: Managing and Resolving Disputes Between Company Founders
Founder disputes can destroy an early stage venture and need to be handled with care, diligence, and wisdom from company counsel.
A souring relationship between company co-founders may have a long-term impact on an early stage venture and may even destroy its ability to succeed. At an early enough stage, company counsel may be able to help warring co-founders settle their differences. When the dispute has already become heated, counsel may need to undertake damage control to ensure that the venture can survive. Below are some important considerations in managing and resolving disputes between co-founders.
Company Counsel Should Assess The Situation, Including The Risk Of Litigation.
Key Takeaway: Counsel should consider providing a neutral evaluation or proposing mediation. If a co-founder has already departed, counsel should assess litigation risk immediately.
Ideally, co-founders will have sought the advice of company counsel at an early stage of a dispute and at a time when they are still constructively listening to each other. As a fiduciary to the venture, company counsel has an obligation to assess the situation and suggest mechanisms to the founders to ensure the ongoing stability of the business. This could include company counsel acting as an early stage evaluator and giving frank advice to the co-founders about the significant downsides of litigation, or proposing low-temperature dispute resolution mechanisms, such as mediation, which can also be effective.
Sometimes, company counsel is only made aware of a co-founder dispute when it is too late to resolve the situation. In a scenario where a founder has already left or been terminated, counsel should assess the prospect of litigation. This may necessitate advising the company to retain all information related to the separation, which may be required to avoid claims of litigation spoliation under applicable law or court rules. Access to shared folders and other online infrastructure should be terminated to prevent potential trade secret misappropriation by the ex-founder. Company laptops or other property should be collected from the ex-founder as soon as possible.
A Range Of Claims Can Be Made By A Departing Founder.
Key Takeaway: Ex-founders can allege diverse claims related to equity, intellectual property, defamation, and wage and hour compliance.
Below are examples of common claims brought by ex-founders:
—Claims for Equity. If the company has failed to properly document its capitalization, an ex-founder can very easily claim significant ownership of the venture. Even where company capitalization is detailed in written stock purchase or voting agreements, an ex‑founder could claim there were additional oral understandings with respect to ownership of the company, including oral promises of future equity, which were never documented. An ex-founder might claim that existing written agreements were secured through fraud or misrepresentation. Thus, even the presence of robust writings may not be sufficient to allay concerns that a litigious ex-founder may one day come out of the woodwork to claim additional equity.
—Wage and Hour and Other Compensation Claims. Many early stage companies shortcut their compliance with wage and hour rules in order to extend their runways, with the understanding that the founders will be compensated for missed backpay at a later financing event. Founders also sometimes extend credit to the business, again, hoping that founder loans will be paid back at a financing. A founder who leaves the venture can take the position that missed backpay constitutes violations of applicable wage and hour laws, or may demand immediate repayment of outstanding loans.
—Infringement of the Ex-Founder’s Intellectual Property: If the ex-founder failed to sign an intellectual property assignment agreement in exchange for founder’s shares, or excluded significant intellectual property from that assignment agreement, the ex‑founder could claim that the company is infringing material intellectual property rights without permission.
—Defamation: To the extent that the ex-founder’s departure becomes public, an ex‑founder could claim that statements made by the company or other founders rise to the level of defamation, if they disparage the ex-founder or impugn the ex-founder’s business acumen.
In addition to the above, an ex-founder can also seek injunctive relief in litigation, for example, a court order enjoining use of the ex-founder’s intellectual property, or seeking reappointment as an officer or to the board of directors.
Counsel Should Secure A Release Of Claims That Confirms Equity Holdings, The Public Facing Message Regarding The Separation, And Clean Title To Intellectual Property.
Key Takeaway: Company counsel must ensure that any release sufficiently addresses the risks unique to founder separations and complies with generally applicable law related to release agreements.
Securing a release agreement with the departing founder is an imperative for company counsel. The release should cover several points. First, the release should expressly describe the amount of equity held by the departing founder so that there is no dispute later regarding ownership. Equity calculations should never be detailed as a percentage of the company, as this creates confusion as to how to calculate the percentage ownership. Instead, the release should simply state the exact number of shares held by the departing founder. The departing founder should also release any claims to any future equity or promises of equity, including company options, warrants, and the like.
Second, the release agreement should detail how the departure will be messaged and framed to the public. Ex-founders typically want the ability to state they are “founders” of the company for purposes of their LinkedIn or other social media profiles. This can be negotiated and incorporated into the release. The release should also detail what each party will say in the event they are asked about the separation, including if or when the company is asked to provide a reference for the ex-founder by a future employer. In particularly emotional or toxic separations, counsel should consider a blanket prohibition on any representations or statements related to the separation or to the business relationship other than those expressly described in the release agreement.
Third, counsel should make sure that the departing founder has assigned over all intellectual property related to the venture. If the departing founder excluded intellectual property from the initial intellectual property assignment agreement executed at incorporation, counsel should inspect those exclusions to make sure the company is not compromised later with respect to intellectual property ownership. It is also good practice to bake in a “further assurances” clause that requires the departing founder to cooperate with the company at a future time.
These points are in addition to traditional requirements associated with separation and release agreements, which can vary by state, and which counsel should also vet. In California, for example, the release for both known and unknown claims must comply with California Civil Code section 1542, and language should be included to comply with that provision of California law. Generally speaking, the release should also exclude claims that cannot be waived or released by private agreement because of public policy. Ex-founders who are over the age of 40 may be entitled to the protections of the Older Workers Benefit Protection Act (OWBPA) of 1990. Counsel must thus check applicable legal requirements that apply to all release agreements, in addition to ensuring that the release adequately captures the circumstances of the ex-founder’s departure. A boilerplate release agreement will not work.
Counsel Should Assess The Risks To The Business In The Absence Of A Release.
Any failure to secure a release will pose significant risks to the company. Company counsel should assess these risks and provide honest feedback to the remaining founders, including how the absence of a release will impact future financings or liquidation events. The company may have to weigh several alternatives, including whether to wind up the business.
While a departing founder will normally have a business incentive to secure a reasonable outcome to maximize the value of their equity, particularly toxic disputes may have emotional components that are less susceptible to reason or economic incentives. Tackling difficult founder disputes thus requires a keen understanding of human psychology in addition to legal sophistication. In all instances, company counsel must remain calm, act in a forthright manner, and have a steady hand. This will give the company the best chance of success to move past the separation.