A bird in a cage or how to keep a funder in a start-up?
When buying a real sector company, the main aspect an investor pays attention to is the real estate, the customer base, and the contracts concluded. The situation is quite different in case of an investor buying a share in an IT-startup. IT start-ups as a rule don't have their own regular client base, they may not even have a profit in the first years because, for example, they are in the development stage of a mobile application and it doesn't bring them profit. The main asset of a start-up is people, and an experienced investor understands this and always aims to keep key people in the company as long as possible after attracting investment.
Below we have analysed the main legal tools in English and US law that are used to protect an investor from a funder leaving a start-up.
Lock-up
Lock-up is a legal instrument that is traditionally enshrined in a shareholder agreement and obliges the funder to refuse to dispose of his share to another person without the investor's consent for a certain period of time. Lock-up prohibits not only the traditional sale, but also gift, exchange and assignment.
When enshrining a legal instrument such as lock-up, it is important to pay attention to the following points:
- Term. Since it is impossible to completely block a funder from leaving a start-up, it is important to determine the length of time during which he needs to remain a shareholder in the company. When restricting a funder's right to sell his share, investors traditionally insist on 2-3 years from the time he enters the business. However, everything depends on the agreements between the parties. And there is always an option for the funder to reduce the term of this commitment.
- The parties to whom the lock-up will apply. Depending on the company's governance structure (decision-making procedure, existence of a collegial/one-man executive body, its composition), there are various options for imposing lock-up restrictions. Among the most widespread ones are the following:
- extending lock-up to all founders,
- extending lock-up only to founders who own a certain percentage (number) of shares,
- extending lock-up only to founders who simultaneously hold a position in the company (e.g. director, CEO, CFO, etc.),
- any combination of these variations (e.g., a founder who owns more than 10% and holds a management position in the company).
- Defining other lock-up restrictions. One option that is often used in lock-up is to exempt a certain % of the stake from the lock-up obligation. For example, a prohibition on selling a certain percentage of the funder's stake is used so that a substantial part remains under the funder's control and his participation in the start-up remains.
Often, the investor's goal is not to protect the startup from a funder's exit, but to protect the startup from becoming a shareholder of a toxic person. Toxic persons include those on sanctions lists, those convicted of economic crimes, etc. - They will cause reputational damage to the company by their presence among the shareholders.
| In case an investor needs to protect himself from such situations, lock-up is not advisable. In such a case, it is better to replace lock-up with an indefinite prohibition on disposing of shares to such a toxic person. |
Share vesting
Another common legal tool used to keep a funder in a start-up is share vesting. In other words, share vesting means receiving a certain number of shares depending on the period of time the funder is in the start-up.
Westing can be:
- Regular. In this type of vesting, shares are awarded over a specified period of time in equal instalments (monthly, quarterly, annually). For example, a funder has been promised 3,000 shares in a company, of which 1,000 will accrue annually (or 83 each month) for three years. Thus, a funder's motivation is to remain a shareholder for a greater amount of time, so that he will eventually own more shares in the company and receive a larger profit when he sells his stake.
- Reverse. Under this type of vesting the funder immediately becomes the holder of the entire amount of shares promised, but if he leaves the company before the vesting period ends his shareholding is adjusted pro rata to the amount of time he has been a shareholder. Using the example in the previous paragraph, the situation is as follows: the funder is promised 3,000 shares on a three year reverse vesting period. After one year, the funder decides to resign as a shareholder. He is then entitled to receive only 1/3 of the promised share, i.e. 1,000 shares.
The good / bad leaver condition
One of the limitations of a funder's exit from the start-up is to define the conditions of a funder's departure from the start-up and the conditions when such a departure is acceptable and when it is not.
Possible examples of "good" and "bad" reasons for a funder to leave:
- Objective reasons that may hinder the performance of his functions (e.g. illness of the funder or a close relative), reduction of the annual minimum wage (if he holds any position), etc. are identified as "valid" reasons for leaving the company.
- "Disreputable" reasons would be (1) a funder's refusal to perform the duties reasonably expected in connection with his function, (2) conduct that discredits the company or causes substantial damage to the company's reputation, (3) dishonest conduct with respect to a material matter or a deliberate attempt to damage the company, (4) a criminal act by a funder that would adversely affect the reputation of the company.
The reason for a funder's departure from the start-up matters because, using the legal instrument in question, the shares of the departing funder are treated differently and, depending on the reason for the departure, the funder is classified as a good or bad leaver. It is on the basis of this classification that the privileges to which a funder may be entitled in the event of a withdrawal dep:
- Good leaver. On withdrawal for 'good' reasons, a good faith funder can expect to receive (1) a gain on the sale of shares which did not accrue to him during the vesting period (if not completed) at a fair market price, (2) compensation. The compensation is calculated according to the number of shares he received in the listing, or calculated according to a predetermined formula (for example, the funder may receive a percentage of the annual turnover or a portion of the investment in the next round).
Bottom line: the funder exits with a certain number of shares accrued during the vesting period and also receives money from the sale of shares that were not accrued to him during the vesting period, and in some cases he may even expect to be compensated.
- Bad leaver. If a funder withdraws for 'no good reason', he must sell all his shares received during the vesting period to other shareholders or the company. Also, he does not profit from the sale of shares not received during the vesting period (if it is not completed).
Bottom line: the funder exits the startup without any shares in that company, and only profits from the sale of those shares that were accrued to him during the vesting period.
In general, under English law there are a large number of legal instruments to protect the investor from the withdrawal of a funder, and we have described just a few of the most common in regulating shareholder relations.
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