Ethan Stone

Ethan Stone

by Ethan Stone, Stone Business Law

First, a quick but important clarification: I’m not your lawyer and this answer doesn’t establish an lawyer-client relationship. I’m giving a generic answer to a generic question to educate the users of this site.

Second, a warning. I’m going to sketch out some of the key issues to consider. As you’ll see, however, this is not a simple question. The answers depend a lot on your specific situation and preferences. Moreover, getting this wrong can cause huge problems down the line. Mistakes in this area regularly destroy otherwise successful businesses. Accordingly, you should not try to do this yourself if at all possible. You need an experienced lawyer who can help you think through your particular issues and come up with a solution that it going to work for you.

That said, here’s an answer:

Whenever two people go into business together, they need to resolve at least four issues. There are more things that it would be good to address and lots of details, but these are the big four:

1. Form of Business: You can go into business with someone by just agreeing to do that. That makes you “general partners” in a “general partnership.” That’s usually a bad idea. For example, general partners have unlimited liability for the partnership’s obligations and unlimited authority to incur obligations without asking the other partner. So you’ll generally want to form a legal entity, such as a corporation or an LLC (there are other options, but those are the most likely). In the process of forming an entity, you’ll need to decide how you want it treated for tax purposes (there are various options) and take into consideration the costs and difficulty of formation and maintenance, as well as friendliness to outside investment, assuming that’s part of the plan.

2. Investments and Equity of the Co-Founders. This may seem obvious and it often is. Often, co-equal founders make the same investment and get the same equity. Depending on the nature of the business and the roles of the co-founders, however, it can get complicated. For example, if the co-founders are contributing different things (e.g. cash and IP rights), they might expect different rights (e.g. the cash guy wants his cash back with a percentage return before the IP guy gets anything).

3. Control and Governance. The issues here (and in the next item) depend significantly on how many founders there are and whether they are equals. If there are two equal founders, the biggest control/governance issue is how to break ties. If you don’t make some plans to deal with that, a good business can go down the tubes, simply because you can’t make decisions. Be cautious about thinking that this will never be an issue for you because you and your co-founder get along so well. A lot of people before you have thought that and nonetheless found themselves in bitter deadlocks. People and relationships change, especially under the pressures of starting a new business. Don’t count on everyone getting along. That said, there aren’t easy solutions to this problem. The solution that suits you best will have a lot to do with your and your co-founder’s personalities and attitudes towards each other and the business.

If there are three or more founders or one of the founders is formally dominant (i.e. will get a voting majority), you need to think about protecting the minority against the controlling person or coalition. Incidentally, a thoughtful controlling person should be concerned about this. It’s a lot easier to use your control decisively if you’re doing it under rules that the other founders agreed were fair. Minority investors who feel they’ve been screwed can usually make a lot of trouble, no matter how well the documents have been drafted to shut them down. If that trouble comes up when a VC or strategic partner is thinking about doing a deal, it could scare them off.

4. Departures and Buy-Outs. This is related to the last item. As with the last item, the main concern is deadlock if there are two equal founders and minority oppression if there’s a controlling founder or the potential for ganging up.

Just like you don’t want to be unable to make decisions, you also don’t want to be stuck, long-term, in a private business entity with someone you can’t get along with. So you also want to provide a mechanism for separating the people if they aren’t getting along without necessarily abandoning the business. One of the more popular methods to deal with this is a “buy-sell” agreement, under which a founder proposes a price at which she is willing to buy the other founders’ stock or, if they prefer, sell hers to them. But there are a lot of possibilities.

Also, founders’ equity usually comes with an expectation that the person getting it will be contributing actively to the business. Accordingly, you want to be cautious about leaving equity (and governance rights) in the hands of someone who is no longer pulling his weight (and maybe never did). So you need to address what happens if someone leaves, voluntarily or involuntarily. Typically, this is addressed in an employment agreement. Various arrangements are possible, ranging from vesting over time to a simple requirement that departing employees sell their stock back to the company at an agreed price.

Finally, if your business might try to attract professional investment in the near term (e.g. angels or VCs), bear in mind that you want as “clean” a situation as possible before they come in. If the founders have complicated, vested rights, that can scare off investors who may think that inserting their own investment into the tangle will be too hard. In the alternative, they may simply ask you to scrap all of the agreements already in place and replace them with a new set. If your business can’t get very far without some outside money, it may be best to do the basics (1 and 2) and defer the more complicated issues (3 and 4) until the money arrives, on the theory that there won’t be much to fight about if it never comes. You might think about specific arrangements under item 3 to allow the majority to change parts of the deal over minority objections to facilitate an investment. Be careful about changes that might have tax implications.