Written by Mark Asfar
Finding a partner to start a business is often compared to marriage: you should only partner with someone if you have known them for years, share a vision of what you want to do together, and have taken the necessary legal precautions. Deciding on a partner (or partners) and a partnership structure can be one of the biggest decisions for determining the success of a business, and is particularly challenging given that this decision is usually made before the business has truly established itself.
The tech world is especially familiar with stories of partnerships gone wrong. There are plenty of anecdotes about roommates and coworkers that got together to start a new business around a web platform, a software or a piece of hardware, only to have things go wrong when money entered the picture. One of the most famous iterations of this story was retold by the movie The Social Network which follows the founding of Facebook by Mark Zuckerburg and Eduardo Saverin. The two started Facebook together as students at Harvard and saw the company rise to fame before Saverin was diluted and pushed out of the company. He went from a controlling stake in the social media revolution to a pittance of shares because he did not carefully protect his rights as a founder. This story has served as a warning to up-and-coming businesses ever since.
With so many horror stories being told in the startup world, people are beginning to give more thought as to who they want to work with, and how the relationship should look. Whether there are a handful of individuals looking to come together to form a new business or an already established business is looking to bring new talent on board, every organization will benefit from carefully considering which participation model works best for its circumstances:
The most simple and traditional way to work with someone in a business is to form a Legal Partnership, which is an agreement between parties to carry on business and share the profits among themselves. These arrangements are governed by the Partnerships Act and govern and empower every partner with certain rights as well as obligations. For example, partners in a Legal Partnership are legally and financially liable for the partnership, so if one partner is unable to pay a bill for a service purchased by the business then the other partners will be obligated to do so. Furthermore, the law imposes certain procedural rules such as the fact that major decisions affecting the partnership must be made by a vote of the majority of partners. These rules can work well for smaller and close-knit partnerships, but if there is any disagreement between the partners it could lead to the business stalling, or a stalemate between the conflicting parties.
It is also very important to know that partnerships can be formally created by signing a partnership agreement, or they can be informally created when parties conduct themselves as if a partnership exists. This means that individuals who are wronged in a partnership-like business arrangement can take legal action and courts can find that an inferred partnership existed with all the corresponding legal and financial responsibilities. There is a range of factors that can create this sort of situation, like if parties to a business refer to each other as partners, or share in the work and resulting profits. They run the risk of having a legal partnership inferred, and if so the partner who has taken legal action may be owed profits or compensation depending on what transpired.
Given this information it makes sense that any business that wants to operate as a Legal Partnership should do so officially with a written and signed partnership agreement. A formalized written agreement can clearly set out the terms and conditions of the partnership, such as what happens when a partner wishes to leave as well as any non-compete terms that are required to protect the business. They can also modify the important procedural rules like what is required to vote on decisions, instead of defaulting to what is in legislation. Uncertainty is a major risk for a new business, and uncertainty about the relationship between the individuals running the business is simply unacceptable. A well-written agreement now could prevent significant problems in the future.
The term partner does not always refer to the Legal Partnership model discussed above. Many people in the startup world use the title of partner to identify co-founders, or active directors or officers, of a business that has incorporated. For example, many people think of Mark Zuckerburg and Eduardo Saverin as partners when they started Facebook, though really they were the co-founders of a business corporation. These days most savvy startups are incorporating from the beginning because of the benefits of the corporate structure. Incorporation offers some protection from liability for the financial and legal responsibilities of other parties, provides tax structuring options, and offers the greatest range of options for involving people in the business. Individuals and other businesses can invest and participate in the company through the acquisition of shares. Shares provide a clear means of determining ownership, rights, and rewarding important contributors to the business’ development. High-value workers or important early investors can receive shares for their contribution, and these can guarantee them a certain amount of value and a voice in the future of the business, but this does not put them in control of the business in the same way as the Legal Partnership. This way the Founders of a company can make sure they maintain the controlling interest of the business, but also attract the team members they need in order to expand.
Of course the corporate model is not perfect. While shares are a convenient way to distribute ownership of the company, situations can be manipulated by cunning parties with knowledge of corporate governance. In the case of Facebook, Mark Zuckerburg convinced Eduardo Severin to step down from the board of directors and subsequently issued shares to dilute his ownership and influence in the company. A similar power struggle famously occurred at PayPal during its earlier days when Elon Musk was the CEO of the company and he was removed from his position by the board of directors (though this did not stop him from later founding SpaceX and Tesla, where he as established stronger control). Perhaps the most famous story of all involved Steve Jobs leaving the company that he founded after the Apple Board of Directors took away his control in 1985. In all of these stories significant share ownership alone was not enough to protect company founders and leaders.
The stories about Eduardo Severin, Elon Musk, and Steve Jobs serve to warn future founders about the dangers of losing control of their companies. After all of their hard work and devotion to their respective visions these individuals were effectively removed from the companies they started. However, this might not have been the case had they taken certain legal precautions. Specifically, they could have sought security in the form of a Shareholders’ Agreement. A Shareholders’ Agreement is a written agreement among the shareholders of a company that outlines their rights and obligations when it comes to share ownership and transfers. They can include fairly common clauses like restrictions that require shares to be offered to other shareholders before they can be sold to third parties. They can also include more specific terms such as a Founders’ Clause, which can protect the shares of the people who built the company from dilution or forced buyout. These documents are very flexible and can be used to set out minority protections, and clear procedural requirements for any conflicts between the shareholders. A properly tailored Shareholders’ Agreement can establish the position of founders, and also give greater certainty to new investors in a growing company.
How Momentum Can Help
Momentum provides new and growing businesses with a range of legal agreements and corporate services. We can sit down for a one-on-one meeting to discuss the nature of your venture and ensure that you are structuring your business in the most advantageous way possible.