Question: I understand that venture capitalists like to include a founders termination clauses in most of their deals. What should I look out for with these termination clauses? And what should I include to protect myself?
Answer by Ethan Stone, Stone Business Law
First, a quick but important clarification: I’m not your lawyer and this answer doesn’t establish a lawyer-client relationship. I’m giving a generic answer to a generic question to educate the users of this site. The information below is general in nature and should not be understood as a substitute for personal legal advice.
Typical venture investment documentation doesn’t include a single “founders termination clause.” It does, however, almost always address the possibility of a founder’s voluntary or involuntary departure. I’ll discuss the typical ways it comes up.
What Are You Defending?
In thinking about this topic, it’s helpful to spend a few minutes thinking about what’s important to you. A crucial question to ask yourself is how you will feel if your investors (and maybe a significant number of your team members) decide in the future that the company needs someone else to lead it. That could happen for a number of reasons: The business might just need someone with skills you don’t have. You might not be getting the job done for whatever reason. Of course, it sometimes results from personal/political infighting. The latter will be the most disturbing for most founders. It’s relatively rare, but it happens.
Broadly speaking, founders tend to have one of two reactions to this question. Some are relatively indifferent to the risk of being kicked out. They are mainly concerned with preserving their equity, not their position in the company. By contrast, some founders have a strong proprietary attitude toward their “baby.” These people are worried about their equity, of course, but equity isn’t enough. If at all possible, they want to stay in the saddle and lead the charge.
How you feel is entirely personal to you. So try to be honest with yourself. Otherwise you’ll end up negotiating for things you don’t really care about or living with deep regret (and, in the worst case scenario, expensive but ultimately pointless litigation) after being removed.
Defending Your Equity
If you only care about defending your equity, you’ll have an easier negotiation. Your main “asks” will be (1) to get a significant percentage of your equity vested upfront, and (2) to get a clause in your employment and stock option agreements that accelerates the vesting of some or all of your unvested equity if you are terminated without “cause.”
With regard to upfront vesting, it’s typically easy to get 25% vested if you’ve already put in significant work and/or money before financing, but hard to get much more than that. If you haven’t really done much work beyond devising a business plan, it will be hard (not impossible) to get much upfront vesting.
With regard to acceleration, if you can get agreement on the concept, you need to concentrate on the definition of “cause.” The most protective versions basically limit it to fraud and conviction of a felony. The farther you get from that (and the less concrete the definition), the less valuable it will be, since it will become easier for the company to stonewall you by claiming cause.
Another issue to consider is to get yourself included in the so-called “participation rights” or “rights to future stock issuances” (less commonly, they’re called a “right of first refusal,” but that term more often refers to a different set of rights). Whatever it’s called, it’s the right to participate in the company’s future stock issuances. That allows you to maintain your percentage interest (and get your share of any other rights future shareholders may get) if you’re willing to stump up the cash. If you’re unlikely to have the cash, of course, the right won’t be useful.
In theory, it would also be helpful to have a right to block proposed stock issuances. In practice, you’ll generally have this if you retain voting control of the company and a majority of the board. If not, you’re very unlikely to get it.
Defending Your Position
If you need to prevent yourself from being kicked out, your best bet is to keep an absolute majority of the voting equity. That’s not always enough because different classes of stock (such as the series of preferred stock in which a VC will typically invest) can have special control rights. But voting control never hurts.
To the extent you can’t keep a majority of the voting power, you can negotiate for the right to name one or more board members (i.e. you) and the person who will occupy your office (i.e. you). The strongest rights in this regard are those included in the corporation’s certificate/articles of incorporation, but a voting agreement between shareholders is also acceptable.
In any event, you should be careful to make sure that you hold this kind of right in your capacity as a shareholder (as opposed, say, to requiring your vote on the board to remove yourself from office). The reason is that a shareholder can almost always vote her shares purely in her own self-interest, without any regard to the best interests of the corporation or other shareholders. That’s not true of a member of the board, who ultimately has a duty to vote in her good faith conception of the corporation’s best interests. Usually, that’s a distinction without a difference. But when the chips are down and people are trying to remove you to “save the company,” it’s best not to have to worry about whose view of the corporation’s best interests is right.
Another caution here is that an employment agreement that allows you to be terminated only “for cause” won’t help you keep your office in the worst case scenario. The reason is that a court is very unlikely to reinstate you to your job if the company breaches the agreement and fires you. It’s much more likely to award you money damages. And even if a court does reinstate you, the litigation could easily take a year or two. So if your goal is to keep the helm, not to get a money judgment, an employment agreement isn’t good protection.
I hope this helps. Good luck closing your financing!