Founder Series: Departing Founders and Founder Fallouts

Orrick's Founder Series offers monthly top tips for UK startups on key considerations at each stage of their lifecycle, from incorporating a company through to possible exit strategies. The Series is written by members of our market-leading London Technology Companies Group (TCG), with contributions from other practice members. Our Band 1 ranked London TCG team closed over 200 growth financings and tech M&A deals totalling $3bn in 2023 and has dominated the European venture capital tech market for 33 quarters in a row (PitchBook, Q1 2024). View previous series instalments here.

Founders are often seen as the heart of a startup. Especially in the early stages, when the idea / technology is still in development and product-market fit remains elusive, investors see founders as the core value of the business. And if you have a co-founder, they are often your most trusted confidant. So, what happens if there is a founder fallout? In the twenty-second instalment of Orrick’s Founder Series, our Employment team and Technology Companies Group offer top tips to help navigate key considerations during these tumultuous times.

Corporate Matters

1. Founders as directors. Within many startups, founders are often also appointed as directors of the company or have a right to appoint themselves as a director. Therefore, when a founder departs or where there is a founder fallout, consideration should be given to the director appointment and removal provisions under the company’s articles of association.

   Where the company has adopted the British Private Equity & Venture Capital Association model form documents, their articles of association will sometimes include fallaway provisions. In a scenario where the founder ceases to be a service provider to the company, these provisions set out that, with effect from the termination date, that founder shall no longer have the right to be appointed as a director and, where such founder is already appointed, they shall be deemed to have resigned.

   Such provisions can be incredibly useful in ensuring that the company (and the board) are not negatively impacted where a founder refuses to resign as a director.

   From the perspective of the remaining founder, thought should be given to board composition. For example, with two founder directors and one investor director, board decisions would have sat with the founders. However, upon departure of one of the founders, this balance shifts. The founder director appointment provisions should therefore be reviewed to consider whether the remaining founder has the power to appoint the second founder directors in this scenario or whether an amendment to the articles of association (which may require certain consents, often of an investor majority or the investor director(s)) to introduce this.

   To the extent a new director is not appointed in the departing founder director’s stead, it should be confirmed hat the quorum requirements for a board meeting can be met by the remaining directors alone.

2. Restrictive covenants (shareholders’ agreement). To the extent the company has a shareholders’ agreement in place, this will often contain restrictive covenants binding the founder following departure. These covenants are separate from the restrictive covenants in a founder’s service agreement, and the restrictive period will often be longer than that contained in their service agreement.

   These should be reviewed and considered in the context of the leaver provisions (see below), especially where there is concern that the departing founder will set up a competing business or damage the company’s business or significantly diminish the value of the business by breaching any of the restrictions.

3. A good leaver or a bad leaver. In venture-backed startups, a founder’s shares will often be subject to “leaver provisions” (also known as reverse vesting provisions). The intention is to reduce the impact of a founder leaving the company by putting some or all of their equity in the company “at risk” (i.e. subject to re-purchase or conversion into economically worthless deferred shares in the event of their departure), typically during a set vesting period.

   Depending on the circumstances under which the founder departed, they may be deemed a “Bad Leaver” (typically a founder who has been dismissed for gross misconduct, fraud, dishonesty or conviction of a criminal offence or who, after ceasing to be a service provider, commits a material breach of their restrictive covenants) or a “Good Leaver” (typically all other leavers).

   The board might also have discretion to deem “Bad Leaver” to be a “Good Leaver,” which provides some flexibility. To the extent such discretion is relied upon, the board should ensure this is clearly documented in the board minutes / director resolutions for good corporate governance and to assist on future due diligence exercise as part of the company’s future financing rounds or exit.

   Where a founder has been issued with restricted shares, additional leaver provisions under their restricted share agreement will also need to be reviewed as their treatment in the event of departure might not align with those under the articles of association.

4. What if the founder also holds share options? To the extent the founder has been granted share options, the treatment of such options in the event of departure should be considered as a separate point to the treatment of their shares under the leaver provisions in the articles of association. Any leaver provisions applicable to those options will often be found in the share option scheme rules or the founder’s option agreement.

   Depending on the type of share option, the option documentation will also likely contain timeframes within which the option can be exercised following departure, or else such option could lapse / lose tax-favoured treatment. The option documentation should therefore be carefully reviewed to ensure all processes, documentation requirements and timeframes with respect to the exercise of any vested options are adhered to.

   Any relevant activity regarding UK options needs to be reported to HMRC annually after 5 April but before 6 July in relation to the preceding tax year. The company will therefore also need to ensure that it complies with these obligations.

5. Filing requirements and updates to the Company’s registers. The treatment of a founder’s equity or options and any changes to their position as director come with filing requirements at Companies House and will need to be reflected in the company’s statutory registers.

   Where some or all of the founder’s shares are converted into deferred shares, for example, board and shareholder approvals will be required. The shareholder resolutions and certain Companies House forms (e.g. Form SH08 (Notice of name or other designation of class of shares)) will be required. The founder’s ledger in the company’s register of members will also need to be updated to reflect the re-designation of their shares. Certain investor consents might also be required.

   If the founder’s shares are being re-purchased, such re-purchase will be subject to certain statutory requirements governing buybacks of shares as well as provisions under the company’s articles of association. These should be carefully reviewed to ascertain whether a buyback of the relevant portion of the founder’s shares is possible.

   To affect the resignation of the founder as a director of the company, they will also need to sign a resignation letter, receive approval from the board (and any additional approvals required under any shareholders’ agreement or similar or the articles of association of the Company) and file a form TM01 at Companies House and update the company’s register of directors.

Employment Matters

6. Distinction between employment and directorship. In the vast majority of cases, founders are directors and employees (regardless of whether a contract of employment exists), and, have separate directorship and employment rights. Both need careful consideration prior to termination.

   For example, terminating a founder's directorship in accordance with the company’s articles of association may still be in breach of certain statutory employment rights and/or contractual terms of employment.

   This could give rise to claims by the departing founder, including claims for unfair dismissal and breach of contract and even, depending on the circumstances, discrimination and whistleblowing.  

7. Following a fair process. If a departing founder has two or more years’ service, they will have unfair dismissal rights. The company therefore needs to have a fair reason to terminate and should follow a fair process for such termination.

   Where the reason for termination is a break-down in the relationship between the founders, it can be difficult to point to a fair reason and explain why the departing founder is the one who needs to go.

   There are five potentially fair reasons for termination: conduct, capability or performance, redundancy, statutory illegality or “some other substantial reason.”

   A break-down in relationship or a loss of trust and confidence are likely to fall into the category of “some other reason,” but these reasons for termination are known to be relatively high-risk and following an appropriate, fact-specific procedure will be critical.

8. Authority to terminate employment. Although an employee can be terminated by anyone within the business with the authority to make that decision on behalf of the company, where a company has only two founders, the exiting founder will often question the remaining founder’s authority to terminate their employment.

   The departing founder may challenge the capacity in which the remaining founder is deciding to terminate their employment and assert that a conflict of interest has arisen (i.e. that the remaining founder is acting in their own interest and not on behalf of the company). Support from the board, for example, can help to demonstrate the remaining founder’s authority.

9. Contractual terms of employment. If the departing founder has signed an employment contract, the notice provisions in that contract should be followed.

   Where there is no employment contract in place, the departing founder will be entitled to statutory notice only, unless they can prove an entitlement to a greater amount of “reasonable notice” based on (for example) company and industry practice and comparators.

   The remaining founder should also consider whether the company is sufficiently protected in respect of its intellectual property and confidential information, and, through post-termination restrictions. If there are vulnerabilities, the remaining founder may consider ways of resolving these – potentially during settlement discussions (see below).

10. Settlement discussions. In recognition of the departing founder’s contribution to the company and the close relationship between founders, a frank discussion, founder-to-founder, is often preferred in practice over, for example, a lengthy and awkward performance process.

    The departing founder will generally be offered a reasonably generous settlement package, where a cash payment, notice arrangements and/or preferential equity terms are agreed.

    Such settlement discussions should always be expressed to be on a without prejudice basis and subject to the exiting founder signing the terms of a settlement agreement that includes a waiver of claims against the company (and any group company) and its employees/officers.

    Where a founder has departed a company, potential investors will take comfort in a settlement agreement that documents their termination and offers closure and certainty.

Founder disputes are incredibly fact sensitive and legal advice should be obtained from the outset. Orrick's employment team advises early-stage companies on all aspects of employment law, including founder disputes. If you would like further advice on the employment issues above, or general UK employment law advice, please contact Nicola Whiteley.

Our London TCG team works with tech companies on all aspects of their business plans: financing strategies, protecting intellectual assets, retaining talent, securing and monetising data and advocating for innovation-friendly public policy. If you would like more details on any of the corporate matters above, please contact Jamie Moore.