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Small businesses and startups Partner Agreements and Entity Formation: a Firm Formation

One of the most exciting experiences for any entrepreneur, such as yourself, is making your company official. However, very few founders take the steps to formalize their company or their relationships on paper.

So why establish a solid foundation for your company?

As outlined in my first “legal strategist” blog post, at some point in the future your company is likely to face unexpected hardships, and you and other founders will face difficult decisions (some of which you won’t all agree on).

One common hardship is when you or another founder decides to part ways the company. Whether leaving is the result of personal hardship, change in circumstances, a dream job, a disagreement on vision or direction or another unexpected disruption, a founder often needs be replaced.

While it may be difficult to find another candidate with similar talents, drive and belief in the company, the situation is vastly complicated when your company structure isn’t configured to allow for replacement as quickly as possible.

Designing corporate documents toward your, and other founders’ best interests, as well as for the longevity of your company, is the best way to mitigate the risks faced every day by the startup community.

Top 5 reasons why companies fail:

  • Lack of founders agreeing upon a mutual company vision
  • Lack of a cohesive plan
  • Undefined or miss defined roles
  • Lack of expertise
  • Lack of clearly defined leadership

When formally establishing a company, I focus on you the founder rather than the company or the entity itself. The process should be about developing mutually agreed upon goals and setting appropriate roles between the founders and any other future employees. With that goal in mind, I will typically ask a series of questions designed to identify all founders’ individual goals, personal strengths and weaknesses and private motivations in forming the company.

By focusing on the founders rather than on the corporate entity, I am able to mitigate the risk of failure as well as identify and discover:

  • Potential issues or “founder feuds”
  • Short- and long-term personal goals
  • Short-and long-term company goals
  • Exit strategies
  • Founder roles and priorities
  • Missing roles
  • Ownership percentages

Once potential issues and short-and long-term goals are agreed upon, then the entity can be set up in a manner that will best shield it against unexpected events and unforeseeable changes in circumstances.

For example, what if your partner’s spouse is diagnosed with cancer and is no longer able to focus on the company? What if another founder is missing key skill sets necessary to implement the company vision? It’s these types of undiscovered, unpredicted and unfortunate events that should be planned for to provide the best odds of success for the new venture.

What are the key steps to a forming your entity?

  • Assigning a value to each and every founder
  • Determining expected or desired exit values and time frames
  • Agreeing to a vesting schedule
  • Agreeing to an acceleration schedule

Why follow these steps?

Assigning different values to each founder is difficult, which is why you might want to skip the step altogether. However, rare is the occasion when each founder brings exactly the same monitory value, experience and skills to the table. By talking about the current and potential value of each founder, ownership can be assigned in a manner that makes sense based on the expected exit while encouraging dedication and commitment to the strengths and assigned role of each founder.

Vesting schedules are typically the longest conversation I will have with you and the other founders. The concern is always: “If I don’t have my shares vested I may lost them.” In reality, I have yet to come across a situation in which a founder “lost out” by applying a vesting schedule.  On the other hand, I regularly become involved in situations where an inequity occurred as a result of the founders failing to utilize vesting schedules.

For example, one founder may shirk their responsibility or just contribute less than everyone else. In these situations, vesting allows for the team to be reconstituted without allowing the shirker to receive a windfall. Regardless of who your partners are, everyone has different expectations on what is an acceptable level of work or “giving 120 percent.”

Having different expectations leads to desertification, particularly when it comes to supporting your family and realizing your dreams. In my experience, it’s best to set up up the company with the best flexibility to achieve the agreed upon long-term goals and consider a fair vesting schedule.

Further, design the company for you and the founders, not for the investor. Agree to accelerate shares on exit. All too often, attorneys fail to provide acceleration clauses to reward you in situations in which a company has an exit event earlier than expected. The cited reason is always to make the documents “investor friendly” or “investor ready.” An investor doesn’t invest in the legal instruments; they invest in the team, the revenue, the user base and in the product or service. Design your company for you and, in this case, if you exit sooner than expected, treat it as reward for exceptional work or as an incentive to overachieve. Don’t give yourself a handicap on day one.  Accomplishment is not as a penalty. Similarly, accelerate your employee shares to incentivize them to also overachieve. Reward yourself, your team and your partners and include an acceleration clause.

What are the key benefits?

In considering you first and encouraging all founders to discuss difficult topics, I am able to gain valuable insights that allow me to structure a company that is a “best fit” for all, thereby mitigating harm to the company if/when a “founder feud” occurs.

By the end of the process you and the other founders are able to identify any differences in vision, roles or expected compensation. This exercise often results in a more solid relationship and understanding of each other as you set out on your new venture.