How startup co-founders can avoid litigation among each other Featured

8:00pm EDT June 30, 2012
How startup co-founders can avoid litigation among each other

While it may be uncomfortable for founders of a new business to talk about issues that may lead to disputes between them in the future, it’s important to address, resolve and document those issues before they start the company. Otherwise, disputes can often lead to litigation.

“Having a written agreement is crucial. It’s one thing to agree upon various issues up front, it’s another to have the agreement in writing so the founders have something to refer to when questions or issues arise,” says Jeremy Suiter, Shareholder and Chair of the Business and Commercial Litigation Practice Group at Stradling Yocca Carlson & Rauth.

“Founders may operate on a handshake, but it can be hard to recall exactly what the terms are later on down the road. It’s important to have something in writing that sets out in detail how you’re going to deal with various scenarios,” he says.

Smart Business spoke with Suiter about what company co-founders should do before forming a company to prevent the often-disastrous results of litigation later on.

What are some common reasons company co-founders might sue each other?

The most common reason involves a fight for company control. A failure to address equity and management rights up front may lead to an impasse down the road. This is particularly common when co-founders reach a stalemate, and there’s no provision for a tiebreaker.

What issues should founders discuss up front?

Prior to forming the startup, founders should discuss their goals and vision. These may include services or products the company will provide, the company’s growth plan and the role of each founder. For example, one founder may see the company as his long-term employer, while another may see the company as a shorter-term investment in anticipation of a liquidity event. Goals are going to change, but founders who discuss issues ahead of time and develop a plan to resolve differences are better positioned to avoid the types of stumbles that can lead to litigation.

What specifically should they iron out?

They’ll want to determine how ownership interests will be divided; how decisions will be made; whether the company will employ founders; and the exit plan if a founder dies or wants to leave the company. It’s also important to have a plan for dealing with events that may change the company or how it operates. There are myriad possibilities, but the most common include selling the company, acquiring another company, taking on new partners, raising money or going public.

What provisions should they include in their written agreements?

Once founders decide which type of business entity they want to form, they should enter into an appropriate written agreement that outlines their ownership interests and explains how the company will operate. The agreement should explain how decisions will be made, who will make them and what to do if founders disagree. For example, the agreement may provide that material decisions, such as selling the company may not be made unless both founders agree, while other decisions, such as the day-to-day operations of the company or expenditures of less than $10,000 may be made by a single founder. There also should be procedures in place for the exit of a founder — voluntary or not — and an explanation of each founder’s responsibilities.

The agreement should specify what happens if one of the founders isn’t living up to their responsibilities, and how to resolve disputes that may arise. Dispute resolution procedures should include provisions requiring founders to mediate disputes before pursuing litigation, and if mediation is unsuccessful, the forum for litigation — court vs. arbitration; litigation location; and which state’s law, or any other rules that the parties may choose, will apply. This final provision is particularly important if founders reside in different states.

What methods can resolve disputes prior to litigation?

The best way for founders to resolve disputes is to be upfront with each other. Maintain a good relationship with your co-founder and try to talk through and resolve issues. Agree there will be times when you’re not going to agree, but for the betterment of the business you’ll try to resolve your disputes.

If this doesn’t work, founders should ask a neutral party to mediate. It doesn’t have to be a formal mediation service; it could be a trusted third party whose recommendation each founder trusts.

What damage can result if litigation occurs?

The time and expense of litigation can be substantial. Litigation often impacts not just the founders, but also company personnel and resources, which can ultimately hurt the business. In extreme cases the company may be dissolved if the founders are unable to resolve their dispute. Under California law, that’s the nuclear resolution where the court dissolves the company and divvies up its assets.

How can founders think of everything they’ll need in a contract up front?

Retaining qualified counsel is a good first step. While every business venture starts off with good intentions, disputes arise and that should be recognized. Qualified business counsel can raise potential disputes and incorporate terms into a written agreement for the founders to resolve up front.

Having industry specific counsel doesn’t hurt but isn’t required. Instead, look for a firm that has experienced corporate counsel involved in company formation and litigation counsel familiar with the disputes that typically arise. They can help formulate an agreement to address the real issues that come up and offer advice on how to prevent those issues from becoming disputes in the future.

Jeremy Suiter is a Shareholder and Chair of the Business and Commercial Litigation Practice Group of Stradling Yocca Carlson & Rauth. Reach him at (949) 725-4000 and jsuiter@sycr.com.

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