It’s likely that co-founders will develop different visions over time for the business they jointly worked to develop. Sometimes, the divergence can be overcome and the founders will be able to concoct a hybridized solution. At other times, the differences are irreconcilable; with stakes and emotions running high, it is easy for the founders’ relationship to become adversarial. In these cases, sometimes one founder will have a clear upper hand (e.g. by being the majority shareholder) but at other times the founders might hold equal authority and are unwilling to budge. This latter situation is known as a deadlock.
The prudent founder will contemplate the eventuality of a deadlock within their Founders’ Agreement, Shareholders’ Agreement, and any other pertinent documents. None of this is to say that a disagreement with your co-founders is imminent, but having a mechanism in place to decide how to proceed ensures the stability of your business, gives all founders ease of mind, and saves time and money which would otherwise be spent fending off lawsuits.
Dealing With Deadlock
Deadlock provisions should establish a process which is fair to all founders while allowing the business to survive any disagreements the founders may have over the management of the business. By agreeing to rules beforehand on what could otherwise be a chaotic disagreement, founders can avoid the outright dissolution of their business which is, sadly, what happens most often in the absence of deadlock provisions. There are several notable ways of handling deadlocks which are discussed below.
A binding confidential mediation is one possible solution, as suggested in this Founders’ Agreement template. The powers of a mediator can vary from making the final decision on their own, to “baseball mediation,” where the mediator simply decides between each side’s position (giving each side the incentive to present their most reasonable position in order to be picked), to “golf mediation,” where the mediator writes down their prescribed solution and whichever founder presents a solution closest to the mediator’s wins. Mediation has its uses, particularly in the determination of factual matters, but it has a limited capacity for resolving complex, and often subjective business issues with unclear outcomes, such as determining the best capital-raising terms or deciding whether to admit a new strategic member.
An escalation mechanism could also be employed, allowing the issue to be escalated to certain key executives on behalf of each member (if put in place) in an attempt to solve the problem; unfortunately, this often results in the same deadlock.
The Founders’ Agreement could provide that the Chair, or particular officers, or an independent third party (if the founders can find a third party they all approve of) have the right to cast a tie-breaking vote in a deadlock scenario (which was not resolved after escalation). Again, this approach might not work in every deadlock scenario such as when a member defaults on its capital contributions. Also, this method hands power over to one party, which is counter to how many founders tend to operate initially.
When founders would rather not involve a third party, they can make use of a buy-sell provision which ends in one founder completely buying out the other. It is a drastic solution, and should only be used as a last resort. Buy-sell provisions can be handled in many different ways, but the following are common arrangements:
- “Russian Roulette.” One founder gives notice to the other founders of what they think the company’s shares are worth. The founder receiving the notice then faces a choice; they must either sell their percentage interest to the other founder at that price or purchase all of the other founder’s percentage interest at that price. This heavily favours founders with access to cash – they can place a value on the shares which they know the others cannot match, and therefore they must be forced to sell.
- “Texas Shoot-Out.” Each founder places a bid of the value (per share) they think the company is worth within a sealed envelope. The highest bidder buys the other founder(s) out.
- “Dutch Auction.” Each founder places a bid at the lowest price at which they would sell their percentage interest (per share) within a sealed envelope. The highest bidder buys the other founder(s) out at the price of the lowest submitted bid.
- “Adjusted Fair Market Value.” Using an expert or auditor’s evaluation to determine the “fair market value” of the percentage interest, and a discount rate, the founder triggering the buy-sell provision will either buy the other member’s applying the discount rate, or sell their percentage interest to the other founder at an equivalent discount.
Buy-sell provisions should only be used as a last resort as the final outcome could leave one founder with 100% of the company, and the others without any share.
These are some of the many options at your disposal as a founder, but this is by no means an exhaustive list. In order to help you decide what’s best for your business, it will always be best to consult a lawyer.
Author: Sahil Kanaya