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    End of the road: The peril of acrimonious founder exits

    Synopsis

    An acrimonious exit of a founder is far from a “Black Swan event”. Though not an everyday feature, there have been several instances globally and in India, where celebrated founders have been dethroned from their beloved enterprises, on account of animosity with their co-founders or investors or both.

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    The equivalent of termination, with or without cause, in case of voluntary resignation of the founder is resignation for “good reason” or resignation without “good reason”.
    The year 2021 that went by was one that would be memorable as the year when the Indian entrepreneurial ecosystem came of age.

    Starting with the number of startups achieving unicorn status to the multiple IPOs, the last year was bustling with activities for startups. The year 2022 seems to be promising too and is expected to continue the buoyancy of 2021.

    Despite the buzz and boom, there can be trouble in this picture-perfect world. One of the most complex issues in the life cycle of a startup is an acrimonious exit of a founder. Such an event has huge business, legal and reputational implications for a start-up as well as for the investor.

    Genesis of acrimonious exits
    Do you know what is the fact that founders of early-stage start-ups are least likely to think of while entering into agreements with their co-founders and investors? The fact that things may go wrong between them, and they may not be welcome in their beloved company anymore.

    An acrimonious exit of a founder is far from a “Black Swan event”. Though not an everyday feature, there have been several instances globally and in India, where celebrated founders have been dethroned from their beloved enterprises, on account of animosity with their co-founders or investors or both.

    There are instances aplenty that can be found in the public domain where legends of the startup world and pioneers of the technology business, had to face the rather unsavory outcome of well-publicized and far from amicable exits from their fabled startups. Without going into the details of these matters (which are extremely complex and nuanced), these exits had the eyeballs of the entire world and were followed by all and sundry. The outcome of such events had grave consequences on some companies and/or the founders. In some other cases, the company or the founder withstood the turn of the tide and came out stronger on the other side.

    Instances of animosity brewing amongst founders have occurred on account of a mismatch in views and objectives in the way the company is to be run. In the event these differences remain unresolved for a sustained period, the risk of a major dispute becomes inevitable. Another instance of animosity amidst founders occurs when one founder seems to become eponymous with the business, while the other founders feel overshadowed by the persona or ostensible hubris of the other founder.

    Things become more complicated when allegations surface against a founder in relation to acts of fraud, moral turpitude, sexual harassment, or misconduct. In scenarios such as these, the other founders, investors, and shareholders may distance themselves from the founder against whom such allegations have been levelled.

    The relationship between investors and founders is complex and nuanced. While the intent for any investment is the growth of the company and to make a good return, in the process sometimes things go wrong and relationships become sour between investors and the founder/founders.

    The instances leading to investor-founder conflict can include lack of transparency in the management of the company, violation of the shareholders agreement, taking decisions in derogation of an agreed business plan, deadlock on major decisions and the business being run in a manner that is detrimental to the eventual exit strategy of the investor.

    But who thinks of this when starting up or raising funds? The positivity of starting something pathbreaking and the adrenaline rush end up overshadowing and repressing any thoughts around possible catastrophes. As more and more instances of founders’ acrimonious exits become common, this topic needs more discussion and consideration.

    Key legal and contractual issues during founder’s acrimonious exit
    One of the trickiest issues in any shareholders agreement/employment agreement of a founder, is dealing with the termination for cause or resignation of the founder and the related claw-back provisions/consequences.

    The termination of the founder can be broadly categorized into two buckets (i) with cause or (ii) without cause. The consequences and impact of a founder’s employment being terminated accordingly, with or without cause, have wide ramifications and implications on such a founder. Consequently, it is imperative that founders are cautious about what is written in their agreement regarding, inter-alia, the following:
    • What constitutes “cause”?
    • Who will determine “cause” and how will “cause” be ascertained?
    • What happens to the shares of the founder in such event?
    • If the shares of the founders are to be acquired on their termination, at what price will the shares be acquired (Face value or market value or pre-agreed discount)?
    • What happens to the rights and obligations of the founders? Will the founder continue to remain a shareholder? and
    • Will the founder be paid severance if terminated without “cause”?
    In a nutshell, “cause” happens to be one the most heavily contested definitions in shareholders agreements and with various instances of allegations of fraud, sexual misconduct and investor-founder conflict surfacing in media reports, investors and founders alike need to be more cautious about what they agree to and write in their agreements. Further, given that a founder generally wears multiple caps, i.e., employee, shareholder and director, there are various legal considerations that need to be kept in mind with respect to each relationship that the founder has with the company and what status the founder holds in case of severance of any one or more or all these roles.

    The equivalent of termination, with or without cause, in case of voluntary resignation of the founder is resignation for “good reason” or resignation without “good reason”.

    When a Founder resigns with “good reason”, similar (though not same) consequences as that of termination without cause occurs. Whereas resignation without good reason could lead to the same consequences as termination with “cause”. Accordingly, the definition of good reason also takes up a lot of importance in any negotiation of transaction documents and has various variations and permutations and combinations depending on the negotiation powers of the founder/startup qua the investors.

    There is no straight-jacket formula for the above and the outcome for what constitutes “cause” and “good reason” and what happens on termination/resignation with or without them is subject to negotiation and each draft or each situation demands a different treatment/outcome.

    Crisis management at the time of animosity

    Despite, having multiple guardrails and safeguards in the documentation, the process of an acrimonious founder exit can be jading even for the toughest of corporate warriors.

    In the extreme situation of founder’s employment being terminated and its far-reaching consequences it is highly possible that any differences and disputes may end up in court and therefore, it is extremely important to carefully read all transaction documents to ensure the exit process is done pursuant to the agreement between the parties.

    As a matter of practice, to avoid any governance issues, startups should adopt internal investigations and internal audits by independent third parties whenever there is a potential issue or allegation of serious offences such as fraud, embezzlement, and moral turpitude.

    Given the amount of media scrutiny, it is also important to have media statements legally vetted to ensure that such statement do not turn out to be harmful. In the long run, a lengthy litigation on account of founder exits is not beneficial to anyone.

    Conclusion
    With the recognition of difficulties posed during founder exits, founders (even as early as seed stage) need to read their term sheets/transaction documents very carefully and negotiate these clauses which affect their economic rights in the company to protect themselves in a scenario of a potential or actual acrimonious exit.

    (Kartik Jain is Partner at JSA. Debottam Chattopadhyay, Associate at JSA also contributed to this article)
    (Disclaimer: The opinions expressed in this column are that of the writer. The facts and opinions expressed here do not reflect the views of www.economictimes.com.)
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