Startup co-founders work late nights on tight budgets to grow a business. But sometimes, personal circumstances can derail a once shared vision.

An underperforming co-founder can neglect business operations, impact the morale of a small team or affect the business’ ability to meet growth targets. So what can you do if you’re running a startup with a co-founder who’s not fulfilling their role? 

Because prevention is better than a cure, we set out what you can do at the outset to minimise the risks of an underperforming co-founder. We have also unpacked some strategies to help you manage and tackle poor performance if it does arise. 

How Can I Reduce the Risk of an Underperforming Co-Founder? 

1. Have Clearly Defined Roles From the Beginning

Starting a business with someone usually begins with some casual conversations and email exchanges.

As the relationship takes shape, you should write down each person’s role in the company in a Founder’s Agreement or, if you are also working in the startup, an Employment Agreement or Contractor’s Agreement. You should also set out each founders’ share ownership in a Shareholders Agreement.

The following table explains each of these documents in further detail.

Document Description Features
Founder’s Agreement

An agreement between two or more co-founders to govern the relationship.

It helps avoid confusion around who is responsible for what in the startup. 

The document should set out:  

  • founder role and responsibilities,
  • compensation,
  • equity ownership and any conditions that attach to the shares (e.g. share vesting),
  • intellectual property (IP) assignment; and 
  • dispute resolution.   
Shareholder’s Agreement

Sets out the relationship between shareholders and directors of the company. This document applies to all shareholders (not just founders).

Startup founders are usually always shareholders and more often the directors.

The document should set out:

  • how the board and shareholders will make decisions and conduct meetings,
  • steps to issue new shares and sell existing shares,
  • directors’ roles and responsibilities,
  • founder share vesting,
  • events that will force a shareholder to exit the startup. These are also known as events of default and can include insolvency or fraud,
  • IP assignment; and
  • dispute resolution.
Employment or Contractor’s Agreement

An agreement setting out your workers’ rights and obligations. Most founders will also be an employee of the company.

But there are situations where the founder will provide services (including personal labour) to the startup through their own company for personal or commercial reasons (e.g. income splitting). If this is the case, a contractor agreement is needed.

The document should set out the employee or contractors:

  • role, responsibilities and hours,
  • pay and entitlements or service fees,
  • method of termination, including notice periods and any reasons for termination,
  • restraint of trade and confidentiality protections for the company; and
  • IP assignment.

2. Equity Ownership

Co-founders decide early in their startup journey how many shares each will receive.

A common mistake that we see founders make is using share ownership to reflect initial cash contributions without considering the long-term consequences. For example, if you contribute $20,000 towards the business’ initial operating costs and your co-founder gives $5,000, it’s not always a good idea to split the company 80/20. As the company grows, a founder holding 20% but working as hard as their co-founder who owns 80% may lose motivation.

We suggest that founders instead treat these initial contributions as a loan, and split the shares in a way that reflects how you intend to run your startup (e.g. 50/50).

3. Share Vesting

Share vesting acts as a restriction period on founder shares, and prevents the shareholder leaving the company with their shares before they have vested. A typical arrangement is that shares will vest after four years, but we have also seen performance-based milestones.

So practically, in a four-year vesting period, if a co-founder leaves the company before one year has passed, they will get nothing. At the one year mark, 25% of the shares will vest and then, from that point onwards, they accrue at just over 2% per month until you reach 100% (assuming it increases monthly).

If a co-founder leaves the company after two years, they forfeit the unvested shares and can either keep the remainder or sell them back to the company for their fair market value. This will depend on the terms of the Shareholders Agreement.

Vesting prevents a founder from being issued with 50% of the company and then leaving a few months later without consequences.

4. Events of Default

An event of default is an action committed by a shareholder that triggers the sale of their shares back to the company. For example:

  • a breach of the shareholders’ agreement which the founder does not fix (e.g. making a decision without the approval of the board or shareholders), 
  • acts of serious misconduct or fraud (e.g. using the startup’s money to fund personal trips overseas), 
  • a bad leaver event (e.g. starting a company in competition with yours); or
  • change in control (e.g. the founder sells their interest in the company that holds their shares).

Where a shareholder commits an event of default, they will have to sell their shares back to the other shareholders or the company. The sale price will be either market value or a discount to market value, depending on the terms of the shareholder’s agreement.

A shareholder who is a director must also resign.

5. Dispute Resolution

Your Founders Agreement and Shareholders Agreement should contain a dispute resolution clause. This sets out the process that you and your co-founder must follow when a dispute arises. Usually, this involves meeting to discuss the issue as well as exploring alternative dispute resolution processes like mediation or arbitration. These methods can be more cost-effective and friendly than going to court and can help preserve the co-founder relationship.

What Can I Do If My Co-Founder is Underperforming?

Even with all the right documents in place, a co-founder may still not perform their role. If you find yourself in this situation, we suggest you take the following steps.

Step 1: Raise your concerns.

Share your concerns with your co-founder in an informal setting. You may start by asking how they feel everything is going. There may be personal reasons that explain their actions, and you want to ensure that this discussion is productive.

You may need to bring up their underperformance during the meeting. Having written documents in place that contain measurable obligations will also help you provide examples of where your co-founder has fallen short in their contributions.

After your discussion, send a short follow up email thanking your co-founder for their time. The email should also set out what steps they must take to address the issue, and what steps the business will take to assist them.

If the problem persists, you should move to step 2.

Step 2: Formal discussion and/or mediator involvement.

If your co-founder continues to underperform, you should have a formal discussion clearly explaining how they are in breach of their obligations to the startup.

Refer to their Employment or Contractor Agreement or Shareholders Agreement to specify the breach, and then follow-up your discussion with an email setting out the steps the co-founder must take to fix the issue. For example:

Thank you for your time today to discuss your commitment to the business. I note that you are not meeting your agreed working hours as set out in your Employment Agreement and we discussed the negative impact this is having on the business.

To rectify the issue, we have agreed that to meet your 37.5 hours per week requirement, that you will attend the office at least 70% of the time (26.25 hours). But, you may work flexibly (outside of standard working hours) and remotely for the balance to ensure you can also attend to your personal commitments.

Please confirm that you agree with this approach by email.

Your co-founder may disagree that they are underperforming and trigger the dispute resolution clause. Referring the issue to a mediator can help ensure the process is transparent and fair.

We also suggest that you provide your co-founder with the opportunity to respond to allegations about their conduct in mediation, to preserve internal relationships.

Step 3: Termination or Resignation

If you want the co-founder to leave your business, seek legal advice.

If you terminate your co-founder, you should provide a written letter or Notice of Termination. This letter should set out the following:

  • reason(s) for the dismissal,
  • the relevant clause of their contract that they have breached; and
  • their final day in the business as an employee or contractor.

Depending on the terms of the contract, you can either allow the co-founder to work through their notice period, or pay it out to them.

If your co-founder resigns, they should provide the startup with a Notice of Resignation (as an employee and director, if applicable). The co-founder usually delivers this in writing and within the notice period set out in their employment or contractor agreement. The company must pay out any unpaid employment or contractual entitlements (e.g. annual leave) and where the co-founder holds shares, follow the exit procedure set out in the Shareholders Agreement.

Practically, a co-founder exit will involve these steps:

  1. The co-founder either resigns and provides the startup with a notice of resignation, or is terminated and receives notice of termination.
  2. The co-founder assigns any IP they created or hold personally to the startup. For example, a trade mark they registered in their name. IP assignment should already be covered in their Employment Agreement or a deed. 
  3. The co-founder sells their unvested shares back to the startup for a nominal value (e.g. $1) and the vested shares for their fair market value. An independent valuer or the board will usually determine fair market value. 
  4. The company will pay the co-founder any final employee or contractor entitlements.
  5. You enter into a Deed of Settlement and Release with your co-founder. This document is optional. It sets out the above steps and confirms the matter is resolved. Co-founders part ways and can’t make any future claims relating to the startup or their departure.

Key Takeaways

When starting a business, you hope that your co-founders will work hard and excel in their role. 

But if this doesn’t happen, having a Founders’ Agreement, Employment or Contactor Agreement and Shareholders Agreement to refer to will help measure performance and identify where a co-founder is falling short. When an issue arises, share your concerns in an informal setting before you consider escalating the matter.

A startup lawyer can help advise you on what steps to take to manage an underperforming co-founder. If you have any questions, get in touch on 1300 544 755.

***

Glen Pauline contributed this article. Glen is a Practice Leader in LegalVision’s Disputes and Litigation team. He has significant experience in conducting litigation in both state and federal courts, tribunals and through alternative dispute resolution, particularly in employment matters. Before joining LegalVision, Glen practised as a barrister at the Victorian Bar for more than 15 years and since 2010, Glen has been a nationally accredited mediator.

About LegalVision: LegalVision is a tech-driven, full-service commercial law firm that uses technology to deliver a faster, better quality and more cost-effective client experience.
Madeleine Hunt

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