Published on January 6th, 2016 by Alan L. Sklover
“Assumptions are the termites of relationships.”
– Henry Winkler
ACTUAL “CASE HISTORY”: Jessica, 36, was more than excited. After five years as Assistant Director of the digital division of a fashion design company, she had been approached by Martin, a colleague she knew from a previous job, about a new opportunity.
Martin was putting together a new venture that would contract out the services of tech-savvy graphic artists, visual designers, and computer coders to corporate app and website developers. Jessica saw the idea as a very good one, as she knew there was a need for such a firm from her work, and to her knowledge no one else seemed to be filling the need on a national level. More than once she had thought to herself, “Someone ought to do that.” Martin had financial backing for the venture from a hedge fund owner, and thought Jessica would be the very best person to help him put together and run the start-up.
What most intrigued Jessica was the opportunity to be a part owner of the new company, something she had often thought about but that had never before come her way. As Martin presented the idea, Jessica would have the opportunity to earn over time up to twenty percent (20%) ownership of the new company.
After discussing it with her husband, and meeting with Martin and the start-up’s financial backer, Jessica decided to “take the plunge.” She was presented with a set of papers that seemed quite simple. She was told that “formal documents” would later be prepared. In the meantime, Martin assured her, they would get things rolling and attend to the “details” later.
After leasing a small office space, hiring office staff and assembling an initial sales team, Jessica and Martin were ready to roll. As anticipated, Martin would be in charge of sales, and Jessica would be in charge of administration. Soon after, the difficulties began.
Martin expected to receive a much higher salary than Jessica would receive; Jessica presumed they would be equal. By happenstance, Jessica learned that Martin would be receiving a forty percent ownership stake, double her own, which did not sit right with her; she presumed they were to be equal partners. The company’s accountant was a cousin of Martin’s, and seemed to answer Martin’s questions, but was always unavailable to answer Jessica’s.
One of the documents that Jessica was given to sign contained a non-compete provision that provided she could not work in this industry for a full year if she was ever to leave, or be asked to leave. Jessica was truly shocked to learn that Martin remained employed by his former employer as a consultant, and so was not devoting full time efforts to this company. Each week seemed to present Jessica with another reason to question the wisdom of her decision to join.
After seven months, Jessica “threw in the towel.” She retained our firm to help her achieve fair separation terms, which proved to be more complicated than expected, and even grew adversarial over time. It was especially difficult to get Jessica’s name removed as a guarantor of the office lease obligations. To make a long story short, Jessica was happy to end the dream, which for her had become something of a nightmare.
LESSON TO LEARN: Forming or joining a start-up company is almost always exciting and exhilarating, but can also be quite disappointing. Creating a new business is difficult, but doing so with others requires more communication, focus, attention to detail and patience than most people imagine. It’s just so easy to get caught up in the enthusiasm.
It’s hard to apply cold reason to hot passion, but it is an exercise in discipline that is highly recommended, especially by those who did not do so, and sure wish they did. Here are the 16 questions I suggest you try to answer if you decide to form or join a start-up.
Every business has its ups and downs, but start-ups have them more commonly and more intensely than established firms. These 16 questions are geared to prospective founders and partners of start-ups, but are also applicable to “early stage” employees, hired after the start-up has gotten going, especially if they are told one day they might become owners by vesting in shares.
WHAT YOU CAN DO: Whether you are forming a start-up with one or two others, or being hired by a start-up, with a suggestion that one day you may become one of the shareholders, you need to ask these questions to understand what you are getting into.
It’s really important that you give these matters serious thought. You might mull them over with friends, and perhaps outside professionals, before you discuss them with your prospective start-up partners, employers and backers. Sure, they are sticky, touchy, and sensitive, but they will be far worse to deal with if and when differences arise after you are inside the start -up. It is far easier to consider what is “fair” if you are not in the middle of a dispute.
Try to make sure that points are raised, decisions are made, and details are known – including the “legal” ones – before you jump aboard a speeding wagon. As noted below, try also to prepare a written list of the things decided, so they can later be looked back upon as the “agreed rules of the upcoming road.”
1. What is the overall vision for the company’s future? The late author Stephen R. Covey, in his best-selling “The Seven Habits of Highly Effective People,” said the second habit of successful people is “Begin with the End in Mind.” Need I say more? Knowing where you want to go makes it that much easier to get there. When dealing with others, the work of determining the shared vision for a new company requires hard work and lots of communications. The end goal – a clear, shared vision – is surely worth the effort.
A clear and agreed upon vision can get companies through difficult times. Lack of a clear and agreed vision often gets companies into difficult times.
2. Have “trusted advisors” been chosen to help put and keep the ship on course? There is just no substitute for experience. I know some younger folks believe that is just an older person claiming to be smarter. No, it’s just a fact that good judgment is not something to be gained by reading a book, capable of being taught in a course, or developed in any manner other than through the trials and tribulations of living through numerous successes and failures.
Connecting the company to trusted advisors – mentors, accountants, lawyers – can help you learn from their mistakes and the mistakes of their clients, instead of having to make all of those mistakes on your own.
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B. Commitments and Contributions
3. Are you and each of the founders expected to be working full time? As Jessica found out, not everyone assumes that being a partner in a company necessarily means working there full time. And, too, to some people “full time” means forty hours a week, while others view it to be “whatever it takes.” If you are working seven days a week, 12 hours a day, during busy times, and your co-founders are carrying a considerably lighter load, resentments will inevitably develop.
4. What financial or other contributions are expected from you and the founders? Different types of expected contributions can include financial contributions, computers databases, logos, licenses, “books of business,” even introduction to industry relations. Once contributed, are they automatically the company’s property, or are they “on loan,” that is, to be “returned” to the original contributor if he or she leaves? If there is a departure or breakup, can you take them back as your own?
In a similar vein, if the company needs you to personally guarantee its credit line, or have your name on the office lease – a common occurrence with many startups – are you prepared to do so? If you leave, do you remain “on the hook?”
Perhaps most importantly, is there a requirement that you dig into your pocket in the future to provide additional funding should the company experience a shortfall? A “call option” on your life savings could prove to be a calamity.
5. What will be your and the founders’ respective responsibilities and roles? Generally, this question is not a difficult one to answer. Each founder or partner will have a pretty good idea of what he or she expects to be responsible for. Perhaps this question would be better framed this way: “Are we certain that each important function will have one person whose job it is to oversee it?
Who will oversee information technology? Legal affairs? Human resources? Vendor relations? Facilities management? Bookkeeping? Strategic planning? Banking? Sales? Payables? Receivables? Production? Communications systems? Intellectual property? Client relations? Promotions? In even the smallest of companies, these and other vital functions must be planned, attended to, and overseen, daily, weekly, monthly and yearly. They don’t, unfortunately, take care of themselves.
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6. What will be the financial backers’ ( a) roles and is their backing (b) secure, (c) limited and/or (d) have strings attached? There is a saying: “In capitalism, the person with the capital usually gets the ism.” Said a bit differently, “He who pays the piper generally calls the tune.” It is quite often the case that financial backers often want to make all major decisions, and keep control of all major functions. On the other hand, some financial backers agree to remain truly “silent” in the running of a company.
My experience is that, where there are one or more financial backers of a start-up, they insist upon their lawyers drawing up all of the operating documents so that, in all events, they have control to protect their investment. This is surely one point on which clarity is essential, and one in which you should think about having your own experienced attorney review.
C. Rewards, including Financial and Ownership
7. Are you and the founders going to take a salary? If so, when will that start, and how much? This is perhaps one of the simplest questions to ask and answer. The important thing is that there not be any surprises, especially as to possible differences in salary levels.
8. What percentage ownership will you, each founder, and each backer receive? This is a question that seems simple, but is anything but simple. While it may be agreed that, for example, the three founders will each have, or have the right to earn, 20% of the ownership interest, and the backers will have 40%, quite often later events can serve to change those numbers depending on what “the papers” say.
In addition to how much ownership each founder, partner or backer will receive, will any of them have the right to earn or purchase more? Might different classes of ownership – such as preferred stock shares, different classes of “membership units,” or other kinds of equity – be created to give one or other kinds of owners greater interests or more control?
Can for example, the company issue additional ownership interests in return for additional funding? That, too, would change the parties’ relative ownership interests. In fact, by addition of additional ownership interests – commonly referred to as “dilution” – a twenty percent (20%) ownership interest could well become a two percent (2%) ownership interest, literally overnight.
Whether or not these things can be done, and whether a majority vote, by a unanimous vote, or some other vote is needed, can be determined only by a careful reading of the company’s shareholder or operating agreement, and asking the necessary questions.
9. Will your ownership interests be (a) awarded upfront (that is, on your “first day”), (b) awarded over time, (c) awarded only after certain goals are achieved, (d) vested in the future, and (e) might they be taken from you in certain circumstances? There are many ways to set up the grant, earning, vesting and forfeiture of ownership interests. Each way has a certain effect, and a certain inherent risk of loss, and must be well thought out.
10. How will day-to-day decisions be made, and who will make them? The decision to purchase pencils is far different than is the decision to purchase patents. There is no simple formula for determining who should make what decisions, and how they are to be made. Commonly, different ways are chosen for (a) strategic, company-wide decisions, (b) hiring and firing decisions, and (c) financial commitments of different levels, with either individual, majority or unanimous levels of owners making the decisions.
Likewise, will there be an Executive Board, Managing Partners or Leadership Council to make the truly momentous decisions that every company needs to make from time to time? If so, will membership be decided now, voted upon later, or rotated among founders and partners in the future?
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11. How will seemingly unresolvable disagreements be resolved? I think this is truly the most important question you should ask. Is there a simple system set up – like “majority rules, or “submission to a confidential arbitration,” or “flipping a coin?” It is far better to have a fair system in place than to “bring in the lawyers” when people are having difficulty even speaking with each other.
Perhaps a mutually trusted advisor, clergy person, or a professional or a leader in the industry? There are now numerous companies in the burgeoning “alternative dispute resolution” industry who offer such services, most of which are comprised of retired Judges. I have successfully used these services many times. In all events, keeping attorneys out of the picture for as long as possible will surely serve your interests.
12. What happens if a founder is not fulfilling his or her commitments; can he or she be forced to depart? More than one of my clients has faced this dilemma, either due to a founder or partner not having what it takes to fulfill his or her responsibilities, or who has lost interest or heart after the business faces discouraging news – a common experience for start-ups.
When not confronted openly and honestly through frank discussion, resentments and morale problems are sure to follow. When there is no established mechanism to resort to, people often don’t raise the issue at all. A practical mechanism to resolve this possible problem is a wise thing to agree on prior to any such problem arising.
E. Future Events and Circumstances
13. Has consideration been given to whether, and how, additional founders, partners or funders may fit into the organization? No one can see the future, but if the company’s vision is to, for example, expand its products and services beyond their present scope, chances are hiring others with subject matter expertise or even acquisitions of other companies may be in the cards. Likewise with bringing in new investors during later funding stages.
Will only founders get founders’ class of stock? Who will decide, and will it be by majority vote, majority vote with limits set, or perhaps unanimous vote, or partners. This question, in particular, may be best determined by consultation with experienced legal counsel.
14. What happens if a founder leaves the company? New and additional founders, partners and funders may arrive, and some may leave, as well. Just as it is advisable to think ahead about how new folks may “come in,” it is advisable, too, to think about what happens if someone – especially those with ownership interests, and “legacy” knowledge of the company, its products or services, its vendor, customers and lenders.
As with the prior question, guidance on such issues might be obtained from an experienced and thoughtful attorney. If legal papers have already been drawn, look for how the legal papers address such an event, because it is quite likely to take place, sooner or later.
15. How will it be decided whether to sell, merge – or even close – the company? Such “ultimate questions” deserve “ultimate answers” before such decisions need to be “ultimately” made. No you can’t plan for everything, but you can try to decide now who can decide later, and who can do the deciding. If you build something with years of toil, you sure don’t want someone else taking it away from you (a) without consulting you, (b) against your wishes, or (c) without getting your fair share from it in the process.
Can the Board of Directors ignore your interests and legal rights? Ouch!
When asked to sign a non-compete agreement, consider asking for release from it, or modification to it, in order to protect your career. How can you respond? How should you respond? Our “Model Letter: Response to Request You Sign a Non-Compete” shows you “What to Say, and How to Say It.™ To obtain your copy, just [click here.] Delivered by Email – Instantly!
F. Most Importantly, Are all Answers to These Questions Set Down in Writing?
16. Are answers to these questions agreed to in some kind of signed agreement? If the answers to these questions are written down somewhere – perhaps in a shareholders agreement if the company is a corporation, or in an operating agreement if the company is a limited liability company, you are one big step forward toward success.
If the answers to these questions are not written down, then making sure that they are – and preferably signed by the relevant individuals to establish they accept them – then by all means it would behoove you and the others you are joining up to “get it into writing,” and signed.
No agreement needs to be complicated, and “legalese” is always to be avoided whenever and wherever possible. In fact, my favorite kind of agreement for new or young companies is a kind of “term sheet” that sets forth the basics in easy to read, short and simple sentences. As Leonardo da Vinci said, “Simplicity is the ultimate sophistication.”
P.S.: If you would like to speak with me directly about this or other subjects, I am available for 30-minute, 60-minute, or 120-minute telephone consultations, just [click here.] Evenings and weekends can be accommodated.
Help Yourself With These and Other
|New Job 3:||Confirming Basic Terms of New Job Offer|
|New Job 5:||Model Response to Receiving a New Job Offer|
|New Job 7:||Checklist of New Job Items to Consider Requesting/Negotiating|
|New Job 13:||Six Important Elements to Request Be In Your Expected Job Offer|
|New Job 15:||Model Request for Sign-On Bonus|
|New Job 16:||Two Model Memos to Protect Your Book Of Business ("B.O.B.")|
|Job Issues 5:||Model Response to Request That You Sign a Non-Compete|
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