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Divestment & dead equity. How do you manage your cap table in unusual situations?


Patricia Borlovan

· 2 min read
Divestment & dead equity. How do you manage your cap table in unusual situations?
Learn how to manage your cap table and the ownership holders in your company in different unusual situations.

Building and growing a company takes a lot of work. From initial funding rounds to product pivots and team changes, founders encounter unforeseen situations.

Founders may leave, investors may change course, and unforeseen events may call for restructuring. In these situations, your focus should be to protect your company and adapt your cap table to reflect the new reality while minimizing the impact on your team and company growth.

In this article, we picked four situations that can lead you to divest your co-founder or encounter dead equity. You might not encounter them very often, but it’s good to be prepared. We'll also provide practical tips and best practices to maintain a healthy cap table, even when going is tough.

1. Divesting a co-founder.

Divesting refers to removing a co-founder from a company's ownership structure, which can happen for personal and performance-related reasons.

Divesting a co-founder has an impact on your cap table.

Changing the equity structure after a co-founder leaves leads to a proportional increase in ownership percentage for the remaining founders and shareholders. The departing co-founder's shares get redistributed amongst those who remain.

It can be a positive outcome, but it's important to understand the dilution effect and ensure a fair deal for all parties.

There are two ways to handle the buyout:

  • Company buyback — The company uses its own funds to purchase the co-founder's shares. It reduces the total number of outstanding shares, increasing everyone else's ownership percentage.

"Outstanding shares" refers to the total number of shares owned by shareholders, including founders, employees, and investors.

  • Investor buyout — An existing or new investor acquires the co-founder's shares. The method does not increase the total number of outstanding shares. New shares are not issued in an investor buyout, so dilution is avoided.

📌 Founder tip: Don’t wait for troubles to find you! Include a few divesting clauses to protect your equity and company in your founder's agreement. Describe in a few words what the process would look like, including valuation methods and possible dispute resolutions that all co-founders agree to when signing the document.

Why is divesting a good solution, and when you need it?

Divesting a co-founder is a serious and often challenging decision for any company, and as we saw earlier, it can happen for personal and performance reasons. A co-founder may leave the company for personal reasons like health issues, family relocation, or wanting to pursue a new company.

If co-founders can't agree on how to move forward due to a personal conflict or one founder becomes incapacitated, divestment can be a way to break the deadlock.

Here are some of the most commonly encountered situations where divesting can be a viable option:

1. Misalignment of vision and goals.

Sometimes, co-founders may start with a shared vision, but their goals and priorities diverge over time. If this misalignment becomes too great, it can hinder the company’s progress, making it necessary to part ways.

2. A shift in focus or a company M&A.

As a company grows, its core business might change, or it can include merging with another company. Your partner might not see the new changes in a bright light or agree with them, even though they are the right solution for the company.

In cases like this, we recommend handling it through open communication, mediation, negotiation, and consulting with your board members. However, divesting them can be a solution if this fails to work and your co-founder decides to leave.

3. Conflicts and ethical concerns.

Personal conflicts or ongoing disagreements that disrupt the workflow and morale of the team can be a major issue. If these conflicts can't be resolved through mediation or compromise, parting ways and divesting a co-founder might be the only viable option.

Similarly, it can be a solution in case of any unethical behavior, legal issues, or misconduct by a co-founder.

4. Health or personal circumstances.

Sometimes**, personal health issues or family matters** may prevent a co-founder from fulfilling their role effectively. While this is often handled with empathy and support, in some cases, it may lead to the need for a change in the founding team.

One personal situation that can impact the company’s cap table is the founder’s divorce or legal issues. If the spouse receives shares, they may also gain voting rights, which can affect decision-making processes within the company. The balance of power on the board or among shareholders might shift, leading to potential conflicts or changes in strategic direction.

Additionally, suppose a founder is involved in significant litigation, such as lawsuits related to previous businesses, personal debts, or other legal disputes. In that case, they might need to liquidate some of their equity to cover legal costs or settlements. It can lead to dilution if new shares are issued or changes in ownership if shares are sold.

Legal issues can also impact the founder’s reputation, especially if the company prepares for a fundraising round, potentially affecting investor confidence. Investors might push for the founder’s removal or restructuring of the ownership to protect their investment.

Tips & tricks for divesting a co-founder

When a co-founder is no longer a good fit for the company, it can be helpful to have a plan in place for how to divest them from their equity. Divesting a co-founder can be a complex and emotionally charged decision, but it is often necessary for the health and success of the startup.

Here are some tips and tricks for divesting a co-founder the right way:

  • Communicate openly and honestly with the co-founder about your reasons for divesting. It’s important to avoid any misunderstandings or resentment.
  • Be prepared to negotiate with the co-founder about the terms of the divestiture. It may include the price of their equity, the form of payment, and any other relevant terms.
  • Get legal and financial advice. Ensure the process is handled properly and that all implications are considered.
  • Evaluate the impact on the company. Divesting a co-founder can hurt the company's confidence and culture. It is important to be mindful of this and mitigate potential problems.

Managing dead equity

Dead equity occurs when shares in a company are held by individuals who are no longer actively contributing to the company's success. A cap table overloaded with dead equity can be demotivating for the current team.

When the co-founder leaves the company or is no longer contributing actively to the company’s success but still owns a significant amount of ownership. In general, departing founders are the main source of dead equity on company cap tables.

As you already saw, founder agreements can solve many problems later if developed early and well enough. Make sure to insert a few lines on how you would address the situation if your co-founder is no longer actively involved or wants to leave the company.

📌 Founder tip: Pawel Maj recommends using the reverse vesting method, and if founders agree to leave within a specified period of time, they are obliged to resell some or all of their shares to the other founder(s).

Why is it important to solve dead equity, and how can it be done right?

The most direct consequence is a de facto decrease in ownership percentage for the remaining founders and ESOP holders, contributing to the company's growth. The co-founder's unutilized shares dilute the ownership of those driving the company forward.

Dead equity in your cap table is a red flag for investors.

Investors often view a cap table with significant dead equity as a red flag. It can signal potential governance issues, a need for more alignment between ownership and contribution, and problems in making strategic decisions. It can make fundraising more difficult and lead to less favorable terms for the company.

Here are some ways to avoid dead equity with a co-founder.

  • Pick your co-founders wisely — Avoid choosing co-founders based only on personal relationships, and make sure that co-founders are passionate, committed, and skilled. Equity splits should not factor in friendship but should be based on each person's value to the company.
  • Think carefully about your equity split — Figure out how you split equity with your co-founders before starting the company. A 50/50 split is not always the best-case scenario. The level of ownership held should reflect each founder’s initial contributions (time, money, intellectual property, assets, etc.), commitment level, network and contacts for raising capital and onboarding advisors, pay equity, skills, and experience.
  • Implement vesting schedules — Use standard vesting schedules for all founders and employees, and avoid acceleration clauses. Do not include acceleration provisions for termination (for any reason) to avoid dead equity, as these can lead to disputes or litigation.

What do you do if your co-founder passes away?

One situation where implementing vesting schedules or having a good founders’ agreement can have a big impact is when one of the co-founders passes away unexpectedly.

The ownership of the deceased co-founder's equity will depend on their will, state law, and existing agreements, such as a co-founder agreement or a buy-back provision. In the case of the unvested shares, they may revert to the company if the deceased co-founder had not yet fully vested in their equity.

However, in the case of vested shares, where the founder has beneficiaries, these are typically inherited by their family members. It introduces new shareholders who may not be familiar with the business or have a strong interest in its operations.

The involvement of new shareholders can lead to potential conflicts, especially if they have differing opinions on company management or strategic decisions.

To manage the company's equity effectively after a co-founder's death, consider these tips:

  • Review existing agreements: Carefully examine the co-founder agreement, buy-back provision, and any other relevant contracts to determine the ownership of the deceased co-founder's equity and any potential rights of the heirs.
  • Communicate with stakeholders: Open and transparent communication with the company's board of directors, employees, and relevant investors is crucial to maintain trust and address concerns.
  • Consider liquidity options: Explore potential liquidity options, such as secondary market transactions or company acquisitions, to provide liquidity for the deceased co-founder's heirs or for the company to repurchase vested shares.
  • Update company records: Make necessary changes to the company's capitalization table and other relevant records to reflect the changes in ownership structure.

Dead equity from departing ESOP holders

When an employee who holds equity leaves the company, the shares they own might be subject to repurchase or redistribution based on the terms of their employment contract or shareholder agreement. It can affect the overall equity distribution among the remaining stakeholders.

Unvested shares.

Similarly to the co-founder situation, if the departing employee has not fully vested their stock options, the unvested portion usually reverts to the company’s equity pool. These shares can be reallocated to new or existing employees, which can help attract or retain talent.

Vested shares.

The challenges come with the vested shares, where the repurchase of shares or reallocation can lead to changes in dilution. If the company buys back shares, it might reduce the dilution for remaining shareholders.

Best practices for managing dead equity with company leavers

  • Having clear policies for ESOP management in case of departures helps smooth transitions. It includes clearly defined vesting schedules, repurchase rights, and redistribution protocols.
  • Keep open lines of communication with employees to explain how departures will affect their equity and ESOP. Transparency helps maintain trust and morale.
  • Seek legal and financial advice to implement a strong employee stock option plan right from the start and address the complexities encountered along the way.
  • Regularly review and update your ESOP plan to align with the company’s growth, changes in the workforce, and strategic goals.

Future thoughts.

Handling unusual personal situations involving co-founders can be challenging for startups, requiring careful consideration of equity management and potential liquidity options.

While unforeseen events like death, divorce, or bankruptcy may disrupt the company's ownership structure, there are strategies to mitigate risks and protect your equity.

Seeking legal and financial counsel from experienced professionals is required to navigate complex situations involving co-founders' equity. Attorneys specializing in business law can advise on contractual agreements, inheritance laws, and bankruptcy proceedings. Financial advisors can guide you on liquidity options, tax implications, and investment strategies.

Last but not least. When addressing the personal situation of a co-founder, show empathy towards the person’s problem but keep a focus on the company's long-term interests. The decisions should be in the business's best interest, preserving its stability and operations.

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