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III.Ensure founders’ are committed to the company’s growth
  1. Founder lock-ins/ restrictions on selling
Rationale behind founder restrictions

By inserting a founder lock-in, founders can be restricted from selling, and even from assigning, transferring, pledging or in any other way encumbering their shares for the duration of the investment. Note that the clause must clearly specify the restrictions on the founder’s shares. The purpose of lock-ins is to ensure that founders are sufficiently interested and invested in the business.

The duration of the lock-in and the extent of shareholding on which the lock-in is imposed is a matter of negotiation, but to start with, investors typically prohibit founders from selling any of their shares until they have exited completely from the company (or for the entire duration of their investment horizon).


Negotiation points
It is advisable for a founder (or a lawyer acting for the investee and the founders) to try to rationalize such restrictions. It is possible to retain the ability to sell partially (so long as the founder(s) continues to retain majority stake in the company) after a smaller mandatory lock-in period (say 1-3 years) over which no shares can be sold. This allows some amount of freedom to the founders to manage their personal cash-flow requirements arising from their assets. This is in the interest of the investor as well because realization of cash from sale of founder shares does not impact the company’s finances. Otherwise, founders may have to borrow money from the company when they need it, or take a higher salary, which will involve funds generated by the company or those invested by the investor. Founders may agree to a lock-in that prohibits them from reducing shareholding below majority.


  1. Execution of employment agreements
Before investing, investors insist that the founders execute an employment agreement to enter into full-time employment of the company. Typically, this is a condition precedent to the investment agreement.
  1. Non-compete clauses in investment agreements
Investors may also usually include a provision prohibiting founders from engaging in any other business, irrespective of whether it is related to the business of the company, so that they are able to work full-time for the company. A non-compete clause prohibits founders from competing with the business of the company over the investment horizon, and for a limited period after they have exited the company by selling their shares or terminated their employment. Since the skillsets, network, customers, resources and other business-related capabilities of a startup are to a large extent dependent on the association of the founders with the startup, it may be possible for a founder to build a competing business on leaving the startup, which is against the investor’s commercial interest.

The non-compete clause may also prevent a founder from soliciting customers away from the startup in case his employment with the company is terminated.


Unlike the case of ordinary employees, to whom a non-compete clause will primarily be applicable while they are under the employment of the company, a non-compete clause on founders can apply till the time they hold shares of the company, even if they are no longer full-time employees of the company. 


Negotiation points on non-compete requirements and employment agreements
  1. Founders should focus on making the clause reasonable. They may expressly clarify that they would continue to retain a passive stake in any businesses they had started earlier (which do not compete with the business of the investee), so long as they are not actively involved in the management of any other business.
  2. Founders can also negotiate the ability to invest (in personal capacity) in new businesses (so long as they are not devoting significant amounts of time and effort to the business).
  3. Sometimes, a competing business may be defined too widely or it may be unclear as to whether certain businesses in which the founder contemplates investing are in competition with the business of the investee or not. A widely worded non-compete clause could even restrict a founder’s investment in a listed company operating in a related industry sector.Founders may narrow down the definition of a competing business in order to have the ability to take the actions mentioned in points 1 and 2 above.


For example, for a startup manufacturing tablets (such as Aakash tablet), would a laptop manufacturer like HP be a competitor? Should its competitors be confined to the tablet industry or extend to smartphone manufacturers such as Sony and HTC as well (even though they may not be making tablets)?


  1. Often, early stage companies tend to have the nearest relatives or spouse of the founder in nominal capacity as a shareholder in the business (these people may also have invested a small amount of money). It is important to ensure that the non-compete restrictions and employment obligations do not apply to such persons at the time of investment.
  2. Although no investor would be interested in investing in competitors, founders may consider inserting clauses prohibiting the investor from investing into other companies  which competes with the business of the investee, especially in case of a strategic investor. The definition of a ‘competing business’ for this purpose may have to be extremely narrow in order for it to be agreeable to the investor.
  1. Reverse vesting
Some SHAs stipulate a ‘reverse vesting’ of founders shares. Under this system, founder’s shares are taken away (they can be allocated to a trust) and vest back in the founders as per a ‘vesting schedule’. As part of the investment transaction, founders must therefore relinquish their shares and then re-earn them as per the vesting schedule. The purpose of the clause is to prevent founders at newly funded start-ups from leaving the company with their shares. This helps investors protect their investment. Reverse vesting terms may be fairly worded to present conditions under which a founder can exit the company with vested shares (called ‘good-leaver’ clauses).

A vesting schedule can in certain cases help the startup as well. Loss of a member of a founding team or another key person can be extremely disastrous for a company for two reasons – not only will the founder’s skillsets be lost to the company in the future, there will be limited equity available with the company to distribute to a new member who is brought in to substitute for the founder’s role.
Generally under such clauses, if a founder leaves on his own or is fired for a reason specified in the agreement– not only is the stake that did not vest in him relinquished permanently, even the stake that has vested can be purchased at an amount which may be meagre compared to the valuation of the company at the time of his leaving. 


Negotiation points on reverse vesting
Reverse vesting is absolutely against the interest of founders – it gives immediate stake for his financial investment to the investor, but makes the founders work for their shareholding. If founders are uncomfortable with the clause, they should negotiate to have the clause removed and insert alternate mechanisms (such as non-compete and lock-ins) to ensure the founder’s commitment to the company. If the investor is persistent, they may consider looking for another investor.

  1. Tag-along
Tag-along clauses are designed to protect the interests of minority shareholders in circumstances where majority shareholders wish to exit the company and sell all (or a substantial portion) of their shares. Tag-along rights tend to discourage founders from diluting or selling their stake in the company by selling out to a third party unless investors are able to exit on corresponding terms.
(Read the chapter on Exit Rights for a detailed discussion on tag-along rights)

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