Tony Hsieh, founder of Zappos with a net worth of over US$800 million, passed away in 2020 without a will despite selling his stake to Amazon. His death led to family squabbles and legal complications, highlighting the importance of succession planning to avoid such disputes, even after exiting a business.
The death of a founder can shake a startup to its core, disrupting leadership and the startup’s ability to continue operating as a business. Founders are often at the heart of a startup’s strategy and operations, so their sudden absence raises crucial questions about the startup’s future.
This post focuses on succession clauses for a founder’s shares, highlighting their role in ensuring a smooth transition. We won’t cover the broader topics of estate planning or business continuity plans (BCP), which may be addressed in the future, though they are also critical parts of business planning.
What happens to the deceased founder’s shares, and who will inherit them?
If a founder dies, his or her shares are first transmitted to their personal representative (also known as an administrator if the deceased dies without a will), who handles the shares as part of the deceased’s estate. The personal representative may choose either to transfer the shares, usually to the heir (e.g., the deceased’s spouse or children) or the person listed in the will, or to apply to be registered by the startup as the new shareholder and, if applicable, a new director (as provided in the startup’s constitution).
If vesting provisions had been in place, the usual practice is for the vesting to cease upon the founder’s death, and any unvested shares would typically have reverted to the startup if the deceased co-founder had not fully vested in their equity.
What succession options and clauses should founders consider?
Broadly speaking, there are eight options that can be incorporated into a written agreement (eg, a shareholders agreement or founders agreement) for restructuring ownership after the loss of a founder, especially with a substantial equity stake in the startup.
Pre-emption rights
This clause gives the surviving shareholders the right of first refusal to acquire the deceased’s shares before they can be transferred to an external party i.e. the heir, ensuring that control remains within the surviving shareholders without obligating them to buy.
Also Read: 7 common legal pitfalls startup founders should avoid
Consider allowing the deceased’s heir to become a new co-founder
Allowing the heir of a deceased founder to become new active members of the management team may be viable if he or she has the necessary skills and qualifications that may align with the startup’s business. However, in many cases, the heir may remain as silent shareholders without any control.
Buyout of deceased founder’s heir shares
In this option, the remaining shareholders may consider buying out the deceased founder’s shares from their heir (usually funded by a life insurance obtained by the present founders).
Permitted transfers (to predetermined individuals)
This allows the transfer of shares to specific individuals (eg, family members or trusts), without triggering pre-emption rights, effectively bypassing the need for shareholders approval while maintaining control within a set of predetermined individuals.
Cross-option agreement (i.e. forced buyout)
A cross-option agreement forces a buy/sell of shares between the surviving shareholders and the deceased’s heir, ensuring that the shares stay within the startup by obligating either side to complete the transaction. A life assurance policy may be already in place to cover the shares value which may be used toward funding the share acquisition by the surviving shareholders.
Compulsory share buy-back
A startup may repurchase the deceased founder’s shares, ensuring that ownership remains within the business rather than transferring to outside parties, preventing unqualified heirs from influencing operations.
This option may be workable if the startup has sufficient liquidity to fund the buy- back or life insurance coverage in place, where the proceeds from the policy are usually to pay for the shares. Once the shares are repurchased by the startup, the shares are cancelled.
Sell to a third party
This option involves selling the entire business to an external buyer, often using existing clauses inside a shareholders agreement like the drag-along right (i.e. allowing majority shareholders to compel minority shareholders to join in the sale).
This may be necessary if neither the surviving shareholders nor the heir wish to continue the startup. However, finding a suitable buyer can be challenging due to market uncertainties, and securing a favourable price may be difficult given the circumstances (on the sale).
Close the startup and liquidate its assets
If the business becomes non-viable after the founder’s death, the shareholders may agree to liquidate its assets, distributing the remaining value to shareholders and heir as a final step, although this often leads to a loss of value.
Also Read: How to craft your startup’s financial projections
This option may only be viable if the startup is solvent and able to meet the outstanding debts and liquidators fees and so on. Also, if you’re venture backed, you may likely need to get the VC’s prior approval too as the norm is to include this as a reserved matter.
What’s next: Incorporating succession clauses and legal advice
It is essential to consult your usual startup lawyer to ensure the proper incorporation of succession clauses and alignment with your startup’s needs.
Depending on the agreement between the founders (and the VC, if venture-backed), these clauses may be incorporated into a shareholders agreement or a buy-sell agreement, helping minimise chaos in the face of the unexpected. In our past experience advising founders, we often recommend incorporating these clauses into the shareholders agreement, ensuring all shareholders are bound by the terms to enhance succession planning.
Additionally, a new constitution (i.e. a statutory document that specifies rules on how a startup is organised and the board of directors and shareholders will be bound by its terms) should be adopted, based on the form of the shareholders agreement to ensure consistency in governance and succession planning.
Valuation of the deceased founder’s shares
Disputes over the value of a deceased founder’s shares may delay business continuity and transfer processes if there is no agreement in place on how the valuation should be conducted and agreed upon by the shareholders. Considerations for share valuation include:
- Fair value: An independent valuer may be appointed by the startup to assess the fair market value of the shares. The founders may also agree in advance on a formula or metrics, such as using revenue multiples or EBITDA.
- Minority stake discounts: If the deceased founder held a minority stake, the valuation may also consider if a discount may be applicable based on the most recent valuation, ensuring that the process remains transparent and to avoid disputes.
Final thoughts
As a startup lawyer, we have witnessed how the death of a founder can cause significant challenges for a startup, particularly in its business continuity.
By incorporating these succession clauses inside a shareholders agreement, startups can mitigate the risks of business disruption and may perhaps increase their business continuity. However, without anything in writing, a startup may likely face conflicts, delays, and uncertainty.
—
Editor’s note: e27 aims to foster thought leadership by publishing views from the community. Share your opinion by submitting an article, video, podcast, or infographic.
Join us on Instagram, Facebook, X, and LinkedIn to stay connected.
Image credit: Canva Pro
The post Preparing for the unexpected: Succession planning and legal considerations for startup founders appeared first on e27.