A Founder Left But Still Owns Equity - What Can The Company Do?

A founder leaving a business does not always mean a clean break.

They might resign from their role, stop working on the business and hand over their responsibilities. Six months later, however, their name is still sitting on the cap table with 20% of the company.

So, what happens to their equity?

The important thing to understand is that leaving the business and giving up ownership are two different things. A founder does not generally lose stock simply because they are no longer contributing to the company.

Whether the company can recover, repurchase or otherwise deal with that stock will usually come down to what was agreed beforehand, what the company's governing documents say and the corporate law of the state where the company is incorporated.

This is why founder exits need to be planned long before anyone is actually heading for the door.

A Founder Can Leave The Business Without Leaving The Cap Table

A founder can have several different relationships with the same company.

They might be an employee, officer, director and stockholder at the same time. Ending one of those relationships does not necessarily end the others.

For example, a founder might resign as CEO and leave the company entirely but continue to hold common stock. Unless that stock is subject to an existing vesting, repurchase, transfer or other exit mechanism, their departure alone does not automatically cancel it.

That means the first question after a founder leaves should not be, "How do we take their shares back?"

It should be:

What do our existing documents actually say?

For a corporation, that can mean reviewing the Certificate of Incorporation, Corporate Bylaws, stock purchase and vesting documents, board approvals and any Shareholder Agreement or Founders Agreement already in place.

For an LLC, the analysis will be different. Ownership and exit rights will generally need to be considered against the LLC Operating Agreement and the law of the state where the LLC was formed.

The key point is that a founder's operational departure and their ownership need to be dealt with separately.

Your Founder Equity Documents Should Deal With An Exit Before It Happens

The best time to decide what happens when a founder leaves is usually when their equity is first issued.

A Founder Stock Purchase Agreement can record how much stock the founder receives, the purchase price, restrictions applying to the stock and what rights the company has if the founder stops providing services.

Founder stock can also be made subject to vesting.

With a typical reverse-vesting structure, the founder receives the stock upfront, but the company has a contractual right to repurchase some of that stock if the founder leaves before the agreed vesting period has run its course. That repurchase right generally reduces as the stock vests.

A Founder Stock Vesting Agreement should make those mechanics clear.

That can include:

• when vesting begins
• how long the vesting schedule runs
• whether there is a cliff
• what counts as the founder ceasing to provide services
• what happens to stock still subject to the repurchase right
• the applicable repurchase price
• how and when the company must exercise its rights
• whether any acceleration applies in specified circumstances.

A Founders Agreement or Shareholder Agreement can deal with the wider relationship between the owners, including decision-making, transfer restrictions, rights of first refusal and what the parties expect to happen if one founder leaves.

These documents need to work together.

A vesting clause is much less useful if the company's other equity documents point in a different direction or nobody followed the approval process required when the stock was originally issued.

You Usually Can't Invent Vesting After A Founder Has Already Left

This is where companies can get into trouble.

Suppose two founders each received 50% of the company when it was incorporated. Nothing in their agreements made either founder's ownership subject to vesting or gave the company a right to repurchase stock if they stopped working for the business.

One founder leaves six months later.

The remaining founder may understandably feel that it is unfair for someone who is no longer contributing to keep half the company. However, that does not itself create a legal right to take the stock back.

The company needs to identify an existing contractual or legal basis for requiring the founder to sell, transfer or surrender their stock.

Delaware law provides a useful example.

Section 202 of the Delaware General Corporation Law allows certain restrictions on the transfer or ownership of stock. These can include requirements to offer stock to the company or other stockholders first, consent requirements and obligations to sell or transfer stock in specified circumstances.

However, the legislation also places conditions around those restrictions. Among other things, a restriction imposed after stock has already been issued generally will not bind the existing holder unless that holder agreed to the restriction or voted in favour of it. Delaware law also contains notice requirements for restrictions on certificated and uncertificated stock.

So, founder exit provisions are not something to improvise once the relationship has already broken down.

If the founder has already left, review the Founder Stock Purchase Agreement, vesting documents, Shareholder Agreement, Founders Agreement, bylaws and any other documents attached to the stock first.

There may already be a repurchase right, call option, right of first refusal or another mechanism that applies.

If there isn't, the company may need to negotiate an exit instead.

What If There Is No Existing Right To Take The Stock Back?

Not having a vesting or compulsory transfer mechanism does not necessarily mean nothing can be done.

It does mean the company should stop thinking in terms of automatically "taking back" the stock.

Instead, the company and departing founder may need to agree on a transaction.

One possibility is for the company itself to repurchase the founder's stock. Another is for one or more of the remaining founders or stockholders to purchase it directly.

Those are legally different transactions.

If the company is buying the stock, its ability to complete the transaction will depend on the corporate law of its state of incorporation, its governing documents, the terms attached to the stock and the company's financial position.

For example, Section 160 of the Delaware General Corporation Law generally permits a Delaware corporation to purchase or otherwise acquire its own stock. However, it restricts certain repurchases where the corporation's capital is already impaired or the transaction would cause an impairment of capital, subject to statutory exceptions.

The fact that the founder and company agree on a price therefore does not necessarily mean the company should simply transfer the money and update the cap table.

The required approvals and documentation need to be considered too.

Depending on the company and transaction, that may involve appropriate Board Consent, a written repurchase agreement and updates to the company's stock ledger and capitalization records.

Alternatively, another founder or stockholder might purchase the stock directly.

Before agreeing to that sale, check whether the company's documents contain rights of first refusal, consent requirements, co-sale provisions or other transfer restrictions. A ROFR and Co-Sale Agreement, where one exists, can materially affect how a proposed transfer must be handled.

The price also needs to be dealt with.

An existing agreement might contain a valuation mechanism or predetermined purchase price. If it does not, the parties may need to negotiate the price or obtain an appropriate valuation.

This is why an exit clause that simply says the company can "buy back the founder's shares" may not be enough. A useful arrangement should make it clear when the right applies, who can exercise it, what stock it covers and how the price is determined.

The Contract Can Matter Long After Someone Stops Working For The Company

A Delaware case provides a useful example of how important stock arrangements can become after someone's active involvement in a business has ended.

In Nemec v. Shrader, 991 A.2d 1120 (Del. 2010), two retired Booz Allen officers continued to own company stock after their retirement.

The company's Stock Plan gave Booz Allen a contractual right, after a specified period, to redeem the former officers' shares at book value. The company exercised that right shortly before a significant transaction that would otherwise have increased the value received by the former officers.

The Delaware Supreme Court ultimately rejected the attempt to use the implied covenant of good faith and fair dealing to provide a protection that was not contained in the parties' contractual arrangement.

The case was not about startup founder vesting, so it should not be read as a direct rule for every founder exit.

Its relevance here is simpler: Delaware courts place significant weight on the contractual rights the parties actually negotiated. The implied covenant is not generally there to rewrite an agreement because events later make the bargain unattractive to one party.

That is another reason to decide what should happen to founder equity while everyone is still on good terms.

A Founder Exit Agreement Should Cover More Than The Stock

Resolving the equity position is important, but it should not be the only legal question asked when a founder leaves.

A founder can have access to some of the company's most valuable assets and information.

They may have created software, branding, designs, inventions, content, processes or other intellectual property. If that IP was created before the company was incorporated or was never properly assigned, the company may discover an ownership gap just as the founder is heading out the door.

A Founder IP Assignment can be used to document the transfer of relevant founder-created intellectual property into the company where appropriate.

Founder exit documents should also consider issues such as:

• resignation from employment, officer or board positions
• confidentiality obligations
• return of company property
• access to company systems and accounts
• IP ownership and assignments
• the agreed treatment of the founder's stock
• any continuing contractual obligations that validly apply after departure.

The exact documents needed will depend on how the founder worked with the company and what was already signed.

The aim is to avoid solving the cap-table problem while leaving the rest of the founder relationship unresolved.

Make Sure The Corporate Records Match The Deal

Signing the exit documents is only part of the process.

If stock has been transferred or repurchased, make sure the company's stock ledger and cap table reflect the transaction. Any required approvals or written consents should also be completed and retained with the company's records.

If the founder has resigned as a director or officer, the company's governance records should reflect that change too.

This becomes particularly important when the business later raises capital or goes through an acquisition.

A former founder continuing to own stock is not automatically a legal defect.

The bigger problem is often uncertainty.

If the cap table says one thing, the stock purchase agreements say another and the board records do not clearly show what was approved, an investor or buyer may have difficulty establishing who actually owns the company and what rights attach to that ownership.

Clear documentation now can avoid a much more complicated cleanup during due diligence.

Plan For Founder Departures Before Someone Wants To Leave

You cannot predict exactly when or why a founder might eventually leave.

You can decide in advance what happens if they do.

Early founder documentation should address ownership, vesting, repurchase rights and transfer restrictions while everyone is still aligned.

The company's wider governance arrangements should also explain who makes important decisions, what approvals are required and whether other owners have rights if a founder wants to transfer their stock.

Most importantly, these documents should match the way the company has actually been set up.

There is little benefit in having a vesting agreement sitting in a folder if the stock issuance, approvals and company records tell a different story.

Founder equity transactions can also have tax, securities and state-law consequences. These can vary significantly depending on the company's structure, state of incorporation and the particular transaction, so appropriate legal and tax advice should be sought before implementing a repurchase or transfer.

Key Takeaways

A founder can stop working for a company without automatically giving up their ownership.

Whether the company can recover or repurchase their stock will usually depend on rights already contained in the company's equity and governance documents, together with applicable state law.

If a founder has already gone and there is no existing mechanism requiring them to sell, avoid assuming the company can simply take the stock back. Review the existing documents first. A voluntary repurchase, stock sale or broader negotiated founder exit may be needed instead.

Founder exits are much easier to manage when the legal documents have dealt with the difficult questions before they become personal. If you would like a consultation on founder exits, you can reach us at (888) 449-8437 or team@sprintlaw.com for a free, no-obligations chat.