Founder’s appointment, exit strategy & pay-out

One of the wisest things while forming the team for a startup is to have a co-founder(s) who is trust-worthy, reliable, mutually coherent, and above all has a complimenting skillset rather possessing similar or competing skills. Founders are clear during the business formation that business and relationships doesn’t go hand in hand, so are prepared to have distinct business boundaries in their partnerships. Yet, the dynamic friction starts off when business starts moving towards some direction and there can’t be multiple captains to steer the ship. It’s common to hear founders exit and conflicts at different stages of businesses. Some of the well-known cases of co-founder conflicts include: Steve Jobs and Steve Wozniak at Apple, Evan Spiegel and Reggie Brown at Snapchat, Mark Zuckerberg and Eduardo Saverin at Facebook.

Some of the ground rules to play safe in the beginning keeping the above factors in mind are:

• Equity splits

  • Consider all the tangible and intangible resources that all founders bring to the table including the capital investments, manpower, domain expertise, business acumen, idea origination, time commitments, network potential, etc., Equity split has to be split rationally on these factors, not necessarily equal.

• Document everything

  • Better stay safe than sorry. With trust and integrity being a necessary factor, there’s nothing like penning it down here. Writing things tries to eliminate abstract and subjective things as much as possible. This also helps to be more professional and stay legally bounded. Hence, try to discuss, agree, and record the necessary matters including inflow, outflow, profit sharing, decision making powers, vesting terms, roles and responsibilities, commitments, etc., Try to have these on formal agreements if not on legal documents, least put on an email.

• Exit plan

  • No one certainly starts a business to close down. Nevertheless, it doesn’t mean not to have an exit strategy in place. This could be based on conditional scenarios and the vested interest of some founders.

Exit pay-out:

Despite if the above rules were not followed, it’s better to have a smoother exit as much as possible. Let us see how to calculate the exit pay-out if one of the founder has to exit a business.

• Determine the total exit value of the business: Calculate the total value of business at the time of exit. If the company is being acquired, acquisition price is the purchase price paid by the acquirer. If the company is going public (IPO), market capitalisation is the share price on the number of outstanding shares. If it’s a secondary sale, then it’s agreed price per share on the number for the number of shares sold. For startups, it’s the current worth/valuation of the entity.

• Founder’s share and exit value: Calculate the founders pay-out based on the equity which should have ideally been calculated based on the above specified factors. If that’s neglected or irrationally divided with 50% share, then a fair value has to be calculated with the consent of all shareholders.

• Adjustment on liquidation preferences (if applicable): Sometimes, investors will have preferred shares with liquidation preferences who gets paid first. If a 2x preference applies, investors with Rs 2 Cr in preferred stock may take Rs. 4 Cr first before common shareholders (like founders) receive anything. If the exit price is below the preference threshold, founders in such situations receive little to nothing.

• Factor in debt, liabilities, and taxes: If the company has outstanding debt, the founders contribution may have a cut. When the exit is in between the financial year then the filings, fees, taxes, and other annual charges have to be considered.

Example of Net exit value calculation for a co-founder:

Consider a simple example: A company ABC is sold at Rs 10 Cr, founder K owns 10% equity, investors have invested Rs. 2 cr with 2X liquidation preference, taxes & filings are estimated at 20% on gains.

Investor liquidation preference pay-out is Rs. 2 Cr x 2 = Rs. 4 Cr, that leaves Rs. 6 Cr for common shareholders (founders). 10% value of Founder K is Rs. 60 lacs minus 20% taxes & other annual charges. Hence, the net exit value for Founder K is calculated to be Rs. 48 lacs.

Other factors that could be considered: Broadly, above factors are to be considered during the founders exit. Additionally, there could be few other factors depending on the business scenarios like additional compensation for founders earn-outs, future price volatility, retention bonuses, etc.,

To summarize, no one may prefer a founding team member to exit. However, better be safe than sorry, have a defined founding team that compliments the business, stay transparent, record everything and if there is a demand for exit, have a smooth transition and exit of the co-founder.  Founders retention or exit should be based on the needs of the business, its shareholders, and customers, and not for emotional reasons to  make it sustainable.

We at #StartXVentureServices can help you to evaluate your business both at the time of founders appointment or at the time of founders exit in a clear, rational terms, so that the exiting co-founder gets a fair pay-out in an amicable manner to benefit the sustainability of your business.

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