Co-Founder Exit? Why Your Shareholders Agreement Matters

Introduction

When starting a business, most founders will focus on growth, customers and building a successful brand. While this is all incredibly important, very few consider what happens if one of the founders decides to leave.

The reality is that co-founder exits are more common than many people realise. Exits can occur for many reasons, including where a founder decides to pursue another opportunity, retires, relocates, experiences health issues or simply loses interest in the business. In some circumstances, disputes between co-founders can make it impossible for them to continue working together.

Very few people start a business with the expectation that one of the founders will leave. As such, failing to prepare for this possibility can lead to significant legal, financial and operational challenges.

This article explores the impact of co-founder exits, why a shareholders agreement is important and what should be considered from the outset to ensure that your business can survive a co-founder exit event.

The impact of co-founder exits

A key issue when setting up a business is its heavy reliance on its founders, particularly in the early years.

Founders often hold key customer relationships, possess specialised knowledge, contribute significant capital and play a critical role in day-to-day decision-making.

When a founder decides to exit, several important questions can quickly arise, including:

• Who will take over their responsibilities?
• What happens to their shares?
• Does the departing founder remain involved in the business and decision-making?
• How will the value of shares be determined?
• Can the remaining founders buy them out?
• What happens if the founders cannot agree?
• Should the founder be prevented from taking clients, employees and opening a competing business?

Without clear frameworks in place, the above issues can lead to disputes that distract from the business and can significantly hinder the business’ success and its ability to continue operating following the founder’s departure.

The importance of a shareholders agreement

Having a shareholders agreement in place is always incredibly important. However, it becomes particularly important where founders establish a company with their friends, family or trusted business partners and assume that things will sort themselves out if someone decides to leave.

Learn more about legal documents new businesses should have in place.

In practice, this is not always the case.

Without a shareholders agreement, there is no clear process governing the following matters, should a co-founder decide to exit the business:

• The transfer of shares;
• The valuation of shares;
• Buyout rights;
• Decision-making processes;
• Dispute resolution procedures; or
• The circumstances in which a shareholder can be required to sell their shares.

Not having a shareholders agreement in place can mean that the parties are required to rely on the company’s constitution, the Corporations Act 2001 (Cth) and costly negotiations to resolve issues.

Disputes between shareholders can result in significant legal costs and ongoing disruptions to the business, particularly where no shareholders agreement is in place.

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Key issues that should be addressed in a shareholders agreement

In addition to or in lieu of employees, you may choose to engage independent contractors in the early stages of your business. However, just like employees, failing to document these arrangements can lead to several issues, including uncertainty and disputes regarding payment terms, ownership of work product and liability.

A contractor agreement should typically address:

• The scope of services to be provided by a contractor;
• Payment terms;
• Intellectual property ownership;
• Confidentiality obligations;
• Liability limitations; and
• Termination rights.

Consideration also needs to be given to the fact that simply calling someone a “contractor” does not determine your relationship with them. There is significant legislation and case law regarding contractors being classified as employees.

Businesses should ensure that their relationship with independent contractors is accurately categorised and properly structured to reduce the likelihood of disputes and liability.

Share transfer provisions

A shareholders agreement should clearly address what happens to a founder’s shares if they leave the business.

Common clauses often relate to whether:

• Shares must first be offered to remaining shareholders;
• The departing founder can sell their shares to an external third party purchaser; and
• Restrictions apply to who may purchase shares and become a shareholder.

Without adequate protections in place, the shares could be sold to an unintended third party and the remaining founders could be required to partner with someone they never intended to do business with.

Valuation mechanisms

One of the most common sources of disputes among shareholders is determining what a departing founder’s shares are worth.

A well-drafted shareholders agreement can establish a valuation process that reduces uncertainty, minimises the risk of disputes or outlines how valuation disputes are to be resolved.

Valuation clauses may include:

• An agreed valuation formula;
• The appointment of an independent valuer; or
• Another agreed valuation methodology.

Good leaver and bad leaver provisions

It is common for shareholders agreements to include “good leaver” and “bad leaver” provisions in a shareholders agreement, with such provisions recognising that not all exits occur in the same circumstances.

For example, a founder who is leaving due to medical issues, retirement or in other agreed circumstances may be treated differently to a founder who resigns shortly after the business is established, breaches their obligations or engages in misconduct.

Appropriately drafted leaver provisions can ensure fair outcomes that protect the interests of the business.

Restraint provisions

When a founder leaves a business, one of the primary concerns for the remaining shareholders is whether that person will use their knowledge, relationships and experience to compete with the business.

A well-drafted shareholders agreement will often include a restraint of trade provision designed to protect the business’ goodwill, confidential information, intellectual property and customer/supplier relationships.

The nature and extent of the restraint may vary depending on whether a founder is classed as a “good leaver” or a “bad leaver”.

Learn more about what you should put in a shareholders’ agreement.

Conclusion

Few businesses are created with the expectation that a co-founder will leave. However, founder exits are a normal part of the business lifecycle and should be planned for so that the business can survive such an event.

By putting appropriate legal protections in place from the outset, businesses can minimise disruption, reduce the risk of disputes and ensure that the business is well-protected from any challenges an exit may cause.

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