Protect the Interests of Co-Founders and Investors with Restricted Rights Agreements

21 Feb Protect the Interests of Co-Founders and Investors with Restricted Rights Agreements

Optimism runs high at the beginning of a new business venture as co-founders set down lofty goals and plan for long-term commitment to one another and the company. However, like many things in life, a business venture may not go according to plan, and, before too long, a founder may be looking to exit the company. 

But what happens to founder equity upon their departure? If the exiting founder becomes permanently unable to work, decides to retire or go on an extended vacation, decides to turn their full focus and energies to other business pursuits (their own or those of others), and drastically reduce their involvement in the business, breaches their fiduciary duties to the company, or leaves to join a competitor, should they really get to keep all of their shares?

At or soon after incorporation, it is important for founders to ensure their expectations align with respect to contributions to the company, as well as vesting and ownership of shares in the event a founder voluntarily or involuntarily ceases participating in the company. It is time, therefore, to draft a Restricted Rights Agreement.

These agreements, sometimes referred to as Restricted Rights Agreements, Restricted Share Ownership Agreements, Restricted Share Purchase Agreements, or Share Restriction Agreements, generally govern the repurchase rights of the company over a founder’s shares upon his or her exit for any reason from the company within a defined period of time.

Establishing the repurchase (or “claw-back”) rights with respect to a founder’s shares at the time of, or soon after, a company’s inception can prevent disagreement or resentment between co-founders over windfall gains or unjust enrichment as well as expensive legal battles. A Restricted Rights Agreement is distinct from a Shareholders’ Agreement and generally covers matters that are not addressed in it. It is therefore important for founders to discuss with their legal counsel as to whether both agreements are appropriate.

R&D LLP helps founders engage in the difficult but important conversations necessary to address these critical issues at the outset of a business so they do not become larger issues later on in the company’s life cycle. We guide companies through the process of drafting Restricted Rights Agreements that balance the protection of a founder’s capital contributions with the reasonable expectations of co-founders and investors.

Issues Commonly Addressed in a Restricted Rights Agreement

A Restricted Rights Agreement should be drafted with a view to the unique and specific interests of a company and its founders. That said, each agreement will generally specify the number of shares that each founder owns, set out a claw-back mechanism on a vesting, reverse vesting, or milestone vesting schedule as to the repurchase rights of the company over some or all of those shares, set out the repurchase price of those shares and specify the events that cause the vesting of the shares to accelerate (e.g., upon the sale of the company).

In pre-revenue, early-stage companies, the founders are typically the brain trusts of the business. As such, for the protection of co-founders, other shareholders, future investors, and other stakeholders, a Restricted Rights Agreement commonly specifies what will happen to a founder’s shares if the founder:

• passes away or becomes unable to play an active role in the company due to illness or disability;
• breaches his or her fiduciary duties or is terminated or removed for cause;
• voluntarily leaves to pursue other work or business ventures;
• breaches a confidentiality or intellectual property assignment agreement;
• commits a crime involving dishonesty or fraud that would adversely impact the reputation of the company; or
• ceases to fulfill his or her contractual duties to the company pursuant to other agreements.

Upon a founder’s exit for any of the above reasons, unvested equity will generally be purchased from the founder by the company for a nominal amount. A Restricted Rights Agreement can, although generally does not, also set out the repurchase rights over vested equity. In such cases, exiting founders will likely want their vested equity to be repurchased at the fair market value (e.g., the price-per-share used in the then most recent private placement financing), but co-founders and investors will not want to spend precious dollars on providing liquidity to someone who is leaving. It is therefore important for the Restricted Rights Agreement to clearly set out the shares to which the claw-back right applies and the price or formula for determining the price of the shares that are subject to claw-back.

Reverse Vesting of Shares

Typically, a founder’s shares will be subject to a reverse vesting schedule whereby unvested shares are subject to the company’s right to repurchase. A reverse vesting schedule is often preferred to a vesting schedule as all the founder’s shares are generally issued upfront, usually at or soon after incorporation, when the corporation is organized. Under a reverse vesting schedule, the company’s claw-back right exercisable upon an exit of a founder will diminish over time as shares gradually vest over a predefined period of time. The longer the founder stays with the company, the lower the percentage of shares remain subject to claw-back.

For example, a founder may hold 500,000 shares at the time of the company’s inception subject to a reverse vesting schedule that sets out that those shares vest (or become released from the company’s repurchase right) at a rate of 25% per year of active service. If the founder leaves after 3 full years of active service, 125,000 of the 500,000 shares would be unvested (or subject to claw-back by the company) and the exiting founder would be entitled to 375,000 shares — representing the equity “earned” over the course of the founder’s 3-year tenure with the company.

The reverse vesting schedule does not need to be linear. For example, a 2-year “cliff” may be set, during which no equity vests, and after which half of all equity vests and is released from the repurchase right with the balance vesting quarterly over 3 years.
 
Generally, a founder’s initial capital contribution to the company is not a cash investment but rather sweat equity, existing intellectual property, know-how, experience, a valuable network, or other intangibles. For this reason, the purchase price of any repurchased shares is typically nominal consideration given that a founder’s shares are generally issued upon incorporation in a significant amount and may not have been fully “earned” by the time of their exit.

Reverse vesting helps to ensure that the founders who are involved in the day-to-day management and growth of the company maintain a significant percentage of the voting and financial rights attached to the company’s shares while providing the company and its stakeholders with a fair and strategic mechanism that balances all parties’ interests upon a founder’s exit.

Founders’ Agreements Put Investors’ Concerns to Rest

A properly drafted Restricted Rights Agreement can also improve marketability of the company to prospective investors by providing them with comfort and confidence that the founders are highly incentivized to continue contributing to the company post-investment, or risk losing a potentially significant portion of their equity upon an early exit. This may be of particular importance to investors who are investing in the founders as much as or more than they are in the business. Most sophisticated investors will generally insist on having a Restricted Rights Agreement in place so that, among other reasons, a founder cannot exit immediately following an equity financing where the fair market value of the shares may have increased significantly.

A company aiming to complete a Series Seed or Series A financing should have in place a well-thought-out Restricted Rights Agreement to demonstrate commitment to the company and to satisfy the market expectations of investors.

R&D LLP Drafts Customized Restricted Rights Agreements for Entrepreneurs

Balancing business interests, legal concerns and corporate finance considerations requires expertise as well as a feel for the nuances that can make a tremendous difference in both the process and the outcome. R&D LLP offers its clients a unique combination of experience and creativity to accomplish its clients’ objectives efficiently and economically. For help with a Restricted Rights Agreement or other similar matters, contact us to learn more about the ways in which we can assist.