Minnesota Start-Up Darwin Lessons Part 2 Wednesday, October 10, 2018 Lisa Holter Ankel, Larry Fox and David Peteler Avisen Legal, P.A. 901 Marquette Ave. S. Suite 1675 Minneapolis, MN 55402
If You Give A Mouse A Cookie… • A Bay Area company in the healthcare space developing SAS product. • Three Founders, Equal 1/3 Shareholdings • Business • Sales • Science • No Vesting or Repurchase • Sales Founder in Financial Trouble
If You Give A Mouse A Cookie… Problem: What if the executives leave? Solution: 1. We implemented a Shareholders Agreement with vesting schedules and buy-back provisions on termination. 2. We issued the stock in certificate form and set up an escrow to hold the unvested shares. 3. Had all founders sign nondisclosure agreements. This is California, so non-competes were not an option.
If You Give A Mouse A Cookie… What went wrong? 1. Science founder couldn’t live on a founder’s non-salary, took a job with a university. 2. He continued to provide some level of service, so we restructured his vesting schedule and let him keep his shares.
If You Give A Mouse A Cookie… Marketing founder couldn’t live on a founder’s non-salary. 1. Constant arguments over why he wasn’t paid out of small change the Company had. 2. Borrowed money from the Business founder. The note was poorly written and unsecured 3. Took $250,000 Company financing as a personal loan secured by his Company shares. - Corporate Opportunity Problem - Corporate Expense – documenting the deal and establishing share escrow - Bad choice by management to try to keep him happy
If You Give A Mouse A Cookie… 4. Sales Founder blew through the $250,000 in a few months. 5. Sales Founder left the Company to work full-time for a Company client he had been assigned to. Diverted the orders of that client to a third party. Company chose not to pursue non-solicitation action. 6. Sales Founder filed for bankruptcy. a. Claimed that the Company shares he owned were part of his bankruptcy estate. b. Claimed that the security interests in his shares were not perfected.
If You Give A Mouse A Cookie… All Is Not Lost. What did we do? 1. We assigned the repurchase right to the Sales Founder’s unvested stock to the Business Founder. 2. Business Founder exercised the repurchase right in exchange for cancelling the personal loan. 3. Lender foreclosed on the remaining shares collateralizing his loan 4. We proved the security interests in the collateral were perfected through possession of the stock in the escrows. 5. The Sales Founder was so buried in his bankruptcy he didn’t want to spend money to fight the Company’s actions in court.
If You Give A Mouse A Cookie… Overall Results: 1. Company made concessions to keep the executive a. Gave up $250,000 financing – critical b. Personal loan from founder c. Lost a key customer when the executive left 2. Went through time, expense, and aggravation to salvage the situation 3. Business Founder repurchased 50% of executive’s stock 4. Lender got the rest of the stock as collateral for his note
If You Give A Mouse A Cookie… Thoughts On This Story 1. If there is a problem executive, it may be best to fire him quickly “Hire slowly, fire quickly” 2. Be careful about granting concessions and special treatment 3. Don’t allow diversion of financing from company 4. Get your legal documents in order a. Shareholder Agreements b. Vesting schedule and repurchase rights c. Establish escrow for unvested stock d. Carefully document loans and transactions e. Document employee performance, build file for termination f. Have good termination clauses in employment agreements g. Consider exercising Company rights quickly and firmly
If You Give A Mouse A Cookie… Do we really need to take all these precautions and do all these legal documents? Maybe not… But ask yourself…
Ask Yourself – Do You Feel Lucky?
The Merger That Shouldn’t Have Been • An automobile dealership formed a sister company to set up a separate auto service facility. • The newly-formed company did some preliminary work, incurred initial expenses, then sat dormant. Finally the decision was made not to set up a separate service facility. • The company’s accountant saw the “abandoned” shell company with losses in it, and decided to make use of the losses.
The Merger That Shouldn’t Have Been • The accountant decided to merge the two companies, so the operating company could take advantage of the losses of the abandoned company. • The accountant filed Articles of Merger with the Secretary of State. The Articles became effective and the merger was completed.
The Merger That Shouldn’t Have Been What Was The Problem? • The accountant called in a panic. He had merged the operating company into the abandoned company, and out of existence. • This violated the terms of several key contracts, including: The dealership franchise The bank loans
The Merger That Shouldn’t Have Been What Did We Do? I contacted the Secretary of State to “undo” the merger. The duty counsel was concerned that this had never been done before. His analogy: you can’t unscramble two eggs.
The Merger That Shouldn’t Have Been • I managed to convince the duty counsel that: The parties at interest (shareholders of both companies) were the same; The parties all agreed to reverse the merger; No third party would be adversely affected by reversing the merger; No tax return had yet been filed based on the merger, so there was no adverse tax effect. • The Secretary of State’s office agreed to “unfile” the merger. • We unscrambled the eggs.
The Merger That Shouldn’t Have Been The Takeaway? • Don’t have your accountant do your legal work. • Call your lawyer.
Golf Gals • Event manager for professional golf association decides to go out on her own and form her own event planning business • She previously worked with a talent management and marketing agency, and has relationships with former athlete clients • She brings with her 2 colleagues who have experience running the events • They agree to be equal owners • No agreement regarding compensation, vesting or repurchase rights
Golf Gals What could go wrong? • Founders didn’t contribute equally to profitability of company • All business leads and revenue came from 1 founder – “rainmaker” • Her compensation wasn’t commensurate with her value • Her co-founders compensation wasn’t commensurate with their value – they were replaceable
Golf Gals Options: • Discussions didn’t resolve the issue • No right to buy others’ out of the business • Rainmaker didn’t want to pay the others to exit a business they didn’t add any value to
Golf Gals Solution: • Dissolve the company • Loss of goodwill and IP which wasn’t assigned to any of the founders • Rainmaker started over
Golf Gals Lessons Learned: • Equal isn’t always fair • Enter into a shareholder agreement with buy-back rights, deadlock options and/or vesting • Treat compensation separately from ownership
Ambitious Employee • Boss Bill heads up Non-profit’s education group • Bill conceives of software tool to schedule education amongst universities and industry players • Bill envisions free use within the education industry for the tool • Bill requests and receives coding resources within Non-profit • Bill assigns employee Ed to manage the project • Ed is a business grad and is working on MBA • Ed sees commercial value in the scheduling tool
Ambitious Employee What could go wrong? • Upon completion of his MBA, Ed decides to quit and form his own business to market the scheduling tool • Ed initially says he has rights in the tool, and requests Non- profit “confirm” this in writing. Does he? • Ed then asks for tool to be given to him for no consideration to continue to develop and market • Ed requests commitment from Non-profit to be beta site
Ambitious Employee How should Bill and Non-profit respond? • Bill wants Ed to succeed • Non-profit doesn’t see commercial value in the scheduling tool • Non-profit agrees to grant ownership rights to Ed, subject to: • Non-profit’s retention of its ownership in the tool • Non-profit’s right (but not obligation) to be a beta site • Ed will offer Non-profit any improvements that Ed makes
Ambitious Employee What happens next? • Ed requests Non-profit become a beta site, Non-profit declines • Ed finds another company to be the beta site • Ed raises money from outside investors • Non-profit continues the development of the tool Ed’s company sends a cease and desist letter to Non-profit to stop it from making improvements, claiming breach of the agreement. Is there a breach?
Ambitious Employee Lessons Learned: • Ed’s tactics from the outset were suspect, should have led to heightened scrutiny • Non-profit’s corporate culture – free use of tool; wanting employee to be successful – restrained it from heavily negotiating the deal • Was it fair for Ed to get ownership rights to a software tool for free? • Simple and friendly agreement could have been more detailed, noting all the rights Non-profit retained
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