all Things Equity
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.
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:
"Outstanding shares" refers to the total number of shares owned by shareholders, including founders, employees, and investors.
📌 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.
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.
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:
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).
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.
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:
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
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.
Want to read more articles like this? Subscribe to the SeedBlink all-things-equity and investment newsletter.
Join our newsletter
Your go-to source for European startup news, equity trends, VC insights, and investment opportunities.