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Startups Gone Wrong: What Happens in a Liquidation and Who Gets Paid

It has been reported that 75% of startups with money raised from venture capital funds go bankrupt.^[i] As one author stated “Venture capitalists who once considered it an unthinkable breach of decorum to put a company into bankruptcy now see it as a way to salvage what they can from their would -be unicorns” ^[ii]

In the past, startup investors were reluctant to finance a troubled company beyond a certain point and were prone to walk away rather than attempt to salvage their investment. This all changed with the sale of patent portfolios by such high-profile companies like Nortel and Kodak. Instead, investors took a more careful look at possible recoveries through asset sales or restructuring of the company’s balance sheet or a sale of the company to third parties.

So, what exactly happens when a startup fails and has to liquidate?

Venture Financing Generally

Financing of new ventures is usually provided in multiple stages beginning with a seed stage investment being made by either an angel investor or a venture capital fund. Assuming that the idea/product is qualified for further investigation and/or investment the process proceeds to the next stage, the so- called startup stage. Here, a business plan is prepared, a management team is formed and a board of directors is constituted, often with a seat or seats being given to a person from the venture capital firm. The following stage of financing occurs when the idea has been transformed into a product of service and is being produced and sold. As the business further matures the venture seeks to expand market share and the investors will seek to evaluate costs, growth opportunities and related matters. The last stage in the investment cycle is the bridge, pre-IPO stage, the goal being for the venture to go public so that investors can exit the venture with a profit commensurate with the risk they have taken.

Claims and Interests Arising During the Startup Cycle

Investors in startup ventures typically receive common stock in the venture although the means by which this is done can vary either through (i) a convertible promissory note, (ii) a simple agreement for future equity, or (iii) a convertible preferred stock investment. Convertible debt, if used, has both debt and equity characteristics and may create some interesting issues in connection with distributions in a bankruptcy case as will be discussed below.

And, in some cases, financing may be secured by collateral including soft assets like intellectual property or hard assets like inventory, accounts receivable, machinery and equipment, and even real estate. At the same time the venture typically will incur unsecured trade debt in the form of rent, payroll, material supplies, machinery and equipment leases, insurance, and other similar costs and operating expenses. Finally, the company may obtain secured loans as a form of financing. The key question is what happens to these debt and equity claims when the startup fails and has to liquidate in a bankruptcy proceeding. Who gets paid and from what sources? The answers lie in various provisions in the Bankruptcy Code.

The Bankruptcy Code Priority and Distribution Scheme

The Bankruptcy Code establishes the following priorities with respect to a Chapter 7 liquidation or distribution to creditors and equity interests under a Chapter 11 liquidating a plan of reorganization:

secured claims (to the extent of the creditor’s interest in the property);
administrative claims;
priority unsecured claims;
unsecured claims; and
equity interests.

A debtor can liquidate in a Chapter 11 case and then use the proceeds to confirm a Chapter 11 plan. As a general rule, a Chapter 11 liquidation is preferable to a liquidation under Chapter 7 of the Bankruptcy Code because in Chapter 11 the debtor remains in possession– meaning that the debtor’s management and board control the case and the sale process. In a Chapter 7 case, a Chapter 7 trustee administers the bankruptcy estate.

All asset sales under the Bankruptcy Code outside the ordinary course of business require bankruptcy court approval under Section 363 of the Bankruptcy Code. Typically, the debtor must show that it has obtained the highest and best bid for its assets through an auction process. In most cases, the debtor will obtain approval in advance of bid procedures, often with a stalking horse bidder already selected. When a stalking horse is used, the bid procedures approved by the court in advance will typically include a break-up fee and expense reimbursement if a higher and better bid is obtained in the sale process. This process typically takes between 90 and 180 days.

Secured Creditors

Secured creditors look to recover against the collateral securing their claims and to the extent the collateral is inadequate to fully satisfy the secured claim the deficiency is usually treated as a general unsecured claim with one limited exception where the secured creditor elects under Section 1111(b) of the Bankruptcy Code to have its underesecured claim treated as a fully secured claim. This election may be made by a secured creditor in connection with a plan of reorganization where the secured creditor believes that the potential appreciation of its collateral will increase to a point where its claim will eventually become fully secured and that bifurcating its claim into secured and unsecured claims is not in its best interests.

Administrative Expense Claims

Administrative claims arise in connection with administration of a bankruptcy estate and generally include ordinary course of business payments incurred and payable during the post-petition period such as real property lease obligations, wages and salaries, taxes and professional fees.

Unsecured Priority Claims

Priority unsecured claims generally consist of unpaid pre-petition obligations for taxes, wages, contributions to employee benefit plans and certain other claims set forth in Section 507 of the Bankruptcy Code. The Bankruptcy Code sets forth certain time and amount limitations on how the claim priority will be determined.

General Unsecured Claims

General unsecured claims consist of all unpaid pre-petition claims that are not secured or priority claims. Typical unsecured claims consist of claims held by trade vendors, landlords, taxing or other governmental authorities, employees, and any deficiency claims held by secured lenders or debtholders, the latter holding claims that may be underwater. The holders of convertible or subordinated debt may also be included among unsecured creditors, but the treatment of these type of claims can be complicated by the terms and conditions of intercreditor agreements and disputes over the valuation of the debtor’s assets.

Equity Interests

Finally, the holders of equity interest rank below all debt clams, but the priority of equity claims will be ranked according to type of equity claim held by the investor. For example, the holders of preferred equity will rank above common shareholders. That said, if the debtor is insolvent, i.e. its liabilities exceed its assets, all equity claims will be deemed valueless, the equity interest will receive nothing in a liquidation and the equity interests will be canceled under a plan of reorganization.

One thing that is important to understand in connection with the treatment of creditor claims or equity interests held by insiders is the concept of recharacterization. If the debtor is a corporation, the Bankruptcy Code defines an insider to include: directors, officers, persons in control, partnerships in which the debtor is a general partner, a general partner of the debtor, and the relatives of a general partner, director, officer, or person in control of the debtor. If the debtor is a partnership, insiders include: general partners, relatives of a general partner in, general partner of, or person in control of the debtor, partnerships in which the debtor is a general partner, persons in control of the debtor. If the debtor is a municipality, insiders include: elected officials of the debtor or relatives of elected officials of the debtor. An insider of an affiliate of a debtor is an insider of the debtor. Managing agents of debtors are also treated as insiders.

Ideally, investors infusing debt capital into a company want to be sure that the infusion is treated as a loan as opposed to an equity investment. Bankruptcy courts may be asked to recharacterize certain loans as equity interests, resulting in the total subordination of the investor’s claim to all other obligations of the company. Recharacterization involves a determination of whether a debt actually exists, and requires no finding of inequitable conduct. Capital infusions by insiders are particularly vulnerable to recharacterization attacks because of their unique relationship to the company. The chance of an otherwise valid loan being recharacterized can be minimized by carefully structuring the cash infusion by properly documenting, effecting and implementing the transaction.

By way of example, the issuance of a bond, debenture, note or the existence of a lien securing the advance is indicative of a loan, whereas the issuance of a stock certificate in exchange for the cash infusion will more likely result in the advance being deemed an equity contribution. The presence of a fixed maturity date, fixed interest rate and a fixed schedule for payments are also characteristic of debt obligations as opposed to equity. Inadequate capitalization of the company is strong evidence of a capital contribution. The determination of undercapitalization is highly factual and may vary substantially by industry and company. Additionally, if the company is unable to borrow funds from other lending institutions at the time the cash infusion is made, the transaction is more likely to be deemed an equity interest. Stated differently, the more aspects of an arm’s length loan transaction the better.

However, even non-insider loans can be rechacterized as equity contributions. Some of the criteria considered by courts in the non-insider situations include whether the relationship between a debtor and a creditor is sufficiently close to suggest that transactions were not conducted at arm’s length. If there is a close relationship the creditor may be considered a non-statutory insider. However, mere participation or influence may not be sufficient even if it includes a seat on a debtor’s governing body. Similarly, the mere participation by subsidiaries in lending and equity relationships with the debtor is insufficient without more to make the lending subsidiary an insider, even if it has a director on the debtor’s board. These issues are very fact sensitive and unfortunately fertile ground for litigation.

As a final word on payments during a liquidation it should be noted that the so-called absolute priority rule ensures a fair distribution of the debtor’s assets by mandating that claims of higher priority are paid in full before claims and interests of lower priority may participate in any recovery. That said, the ranking of claims and interests may be modified if creditors or equity interest holder creditors agree to a different treatment. For example, a senior class of claims or interests may agree to allow a junior class to receive a distribution or larger pro rata distribution in order to facilitate confirmation of a plan of reorganization.

Administration of the Bankruptcy Estate

Individual creditors and equity holders play a limited role in a liquidation under either Chapter 11 or Chapter 7 of the Bankruptcy Code. In a Chapter 11 case, a creditors’ committee (and sometimes an equity committee) is appointed and hires professionals to generally represent the interests of creditors or equity holders. Of course, individual creditors and equity holders can hire counsel and participate in bankruptcy cases in connection with issues affecting their particular interests, but the committees typically will take the lead on most issues.

During the bankruptcy case the board of directors continues to meet regularly and continues to be responsible for the company’s strategic decisions. However, any of its decisions regarding actions outside the ordinary course of business will be subject to the approval of the bankruptcy court.

Importantly, shareholders’ rights In bankruptcy are effectively superseded by the bankruptcy process, and strategic decisions that would be subject to a shareholder vote outside bankruptcy are instead made by the directors and officers for the benefit of the entire estate, often in consultation with a creditors’ committee or other key constituents, and are subject to approval of the bankruptcy court.

Takeways

Investing in or providing financing to startups is risky and the liquidation process of the company and distribution of the enterprise value can be challenging because of the treatment of claims and interests under the Bankruptcy Code. That said, investors have learned that rather than abandoning their claims and walking way, there are ways to potentially recover the value of one’s investment provided that you have a good understanding about the liquidation process.

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^[i] See,www.startupover.com/en/author/andres-dusi/ (April 2014)

^[ii] “The Latest Craze in Silicon Valley: Bankruptcy”, by Daniel Fisher, Forbes Staff, March 2017

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Equal Isn’t Always Fair: How to Divide Founders’ Equity

Author Katherine A. Heptig 1 Comment

When starting a business, there are numerous decisions that must be made by the owners at the outset. One rises above all others, however, and becomes the proverbial elephant in the room – how to divide the founders’ equity.

The easiest answer, an even split of equity among the founders, isn’t necessarily the best, even if it sidesteps the founders’ emotions and egos. The primary shortcoming of this approach is that it fails to take into consideration the relative contributions being made by each individual. Ideally, the value of those contributions relative to the value of the enterprise would be the basis for determining how to apportion the equity. Unfortunately, in the context of a startup, valuation is far from an exact science.

Valuation, the Value Vacuum

A startup, by its nature, has no history. There are no arm’s-length transactions to use as a means of calculating the business’ value, so assessing or even trying to predict that value is difficult. In addition, each founder likely brings something unique to the venture. Perhaps one of them had the original idea but has no business experience, while others have executive-level experience in the industry, or startup capital and an extensive business network. What impact will each of those contributions ultimately have on the success of the business? The challenge here is really twofold – the founders aren’t sure what they are giving up to each other in value, nor what the venture will get back from each in return.

Believe it or not, when advising startup founders, the two best pieces of advice I give to help guide them through the process come from Albert Einstein and Wayne Gretzky. You may wonder whether a physicist/Nobel laureate and a hockey legend ever gave business advice, and the truth is, I’m not sure either of them ever did. But, taken together, their quotes encompass the guiding principles that should be used by founders when deciding how to divide their initial equity.

“I skate to where the puck is going to be, not to where it has been.” – Wayne Gretzky

Gretzky’s notion of looking forward is an important piece of the puzzle for business founders. In the context of a startup, founders often get caught up arguing about how they got to where they are today – who had the original idea, who was willing to contribute capital, who has relevant business experience from a prior position. While each of these considerations is relevant and may be important, it’s equally important for the group to consider what happens next, when the startup phase is complete and the doors are open for business. Although it’s important to consider what background, experience, education and skills a founder is bringing to the enterprise, it’s also important to look ahead and try to determine each founders’ potential impact and level of commitment to the business. The founders, like Gretzky, literally need to try to stay ahead of the game.

“Not everything that can be counted counts, and not everything that counts can be counted.” – Albert Einstein

Each founder has gotten a seat at the table because he/she is viewed by the others as a critical piece of the team who brings something valuable to the venture’s success. The nature of those specific contributions is vast but can generally be grouped into categories, for example:

the original idea
funding/capital
relevant experience
business acumen
applicable skills
industry know-how
network/contacts
pre-existing intellectual property
time commitment/sacrifice
business responsibilities

A simple approach may involve quantifying the contribution in some tangible, material way. For example, some founders try to translate each of these categories to a dollar figure. The problem with that approach is that some of these categories don’t lend themselves as easily to being “measured” in this way. Certain things that are easily quantifiable, like capital, may ultimately be less valuable to the success of the business than a more conceptual contribution that is harder to label with a dollar figure, like industry know-how. In other words, what ultimately “counts” may be difficult to measure.

Another mistake founders often make is trying to equate their respective contributions to an equivalent employee salary. Founders should avoid the temptation to simplify things in this way. The value of a founder’s work for a potential employer may only be a fraction of what some of these contributions may ultimately yield for the business, in part because salaries are determined by a variety of factors and may differ greatly among industries. In addition, the nature of business valuation is to take into account certain temporal factors and risk adjustments. Neither of these fundamental components of business valuation would be reflected in a determination based on a snapshot of an individual’s worth to the company, particularly at inception.

Putting it All Together, Equity Split

There is no single, authoritative formula for arriving at the optimal equity split. The best and most tenable result will come from a process guided by principles that each founder believes to be relevant and fair. That isn’t to say that settling on the final split will be easy. However, coming to consensus early on the short- and long-term needs of the business and the founders’ respective contributions will minimize the potential for friction and, ultimately, disengagement. A thoughtful process has the greatest likelihood of yielding a result that is acceptable to all.

Once the founders are all in agreement as to what it will take to make the company succeed, they should work backwards, looking at the categories of contributions and assigning a relative weight to each. This may be the hardest part of the process, as each founder may look to convince the others that the categories in which he/she will make the greatest contributions are the ones that should be most heavily weighted. The partners must work together to determine the relative importance of each category. Then, they can determine the equity split through a weighted calculation of their respective contributions. Taking this quasi-mathematical approach may serve to eliminate some of the more emotional, subjective arguments that each founder will undoubtedly use to plead his/her case.

The founders should strive to be patient with each other, listening to each other’s concerns and asking questions to help narrow down the areas of potential disagreement. Such a process may feel a bit more cumbersome than simply splitting the equity evenly, but it will be time well-spent if the process meaningfully engages each founder. An equity split derived from shared principles is more likely to be accepted and respected by all.

Other Considerations – Vesting and Dilution

Founders should keep two other important concepts in mind when starting down this road. No matter how the initial equity is divided among the founders, all equity interests should be subject to a vesting schedule. This way, each founder will bear less risk upon an unexpected departure of an individual they deemed critical to the venture. The vesting schedule can be customized however the founders wish, based on any combination of time and/or performance-based conditions, but I always counsel my clients to place some restriction on the ability of a founder to walk away with a significant ownership interest in the startup stage.

Also consider dilution when formulating the initial equity split. Many startups pursue equity financing from outside investors. Successful businesses may also use equity as a compensation tool to attract and retain talented executives. In these cases, the issuance of additional equity will dilute the initial founders’ equity. Founders usually give themselves pre-emptive rights in order to maintain their initial ownership share, but typically that anti-dilution protection requires an actual purchase of additional equity. The founders should create one or more models for a future capitalization table to account for these additional issuances and make an informed decision about splitting the initial equity. If market demand or a new phase of the company’s growth is what triggers the issuance of additional equity shares, a founder who has failed to consider that potential dilution may realize that he/she doesn’t have the opportunity to participate in the appreciation of the company’s value to the extent that was expected.

While there isn’t necessarily a clear-cut formula to divide founders’ equity, the result should be derived from a process that feels right to the group. If they succeed with this initial agenda item, they will likely spend less time looking backward, second-guessing the decision that they collectively made, and more time focusing on moving the business forward and the bright future that potentially lies ahead.

9 Questions When Dividing Founder Equity

Author Charles Weinstein Leave a Comment

A trio of 20-somethings has a great new product idea tied to the gig economy. Each brings something unique to the table, and all are committed to getting this disruptive innovation to market. While they have to address a myriad of issues, one issue they overlook at their peril is dividing ownership in this embryonic company.

Startup Equity Distribution

Splitting startup equity among founders can be an emotionally charged experience. However, there are some tips for refining the process:

Are All Founders Created Equal? Topping the to-do list is deciding if the founders will split equity evenly or unevenly. While expedient, this approach may not reflect the relative contributions of the founders. Will an equal ownership split impede future decision-making because founders have the same voting rights? There’s no one-size-fits-all answer. Take the time to fully examine the many facets of equity.
What factors would favor an uneven split? This is the age-old question of ideation versus execution. Are you betting on the jockey or the horse? The answer is really both. Look holistically at who is investing capital, bringing in key contacts, providing elbow grease and leveraging experience. Decide if more risk and sweat deserve extra equity.
When do we tackle this issue? There’s no exact time; it can take years for an idea to turn into a business. However, the equity distribution decision should be made early in the process, prior to external capital investment. As you reconcile this, take some time to get a lay of the land now and what it may be in several years. Have a discussion that is open, thorough and practical.
How can we determine the best unequal split? There are some guidelines you can use. It can be milestones based on owners’ expected roles and performance, or you can assign a weighted average to some of the aforementioned parameters to arrive at an “equity score.” There are several online equity calculators you may want to try.
How about a vesting schedule? To really gauge the founders’ commitment, equity might vest over several years. VCs generally like to see a one-year cliff; if an owner leaves within a year of formation he/she walks away from all or most of his/her equity.
Are there equity levels? First, determine and allocate shares for founders and then establish an option pool for key current and future employees. Explore phantom stock as an alternative incentive.
Are there tax implications? Shares are often used to lure staff and talent. According to Internal Revenue Code Section 83B, company founders can elect to pay tax on unvested restricted shares when they are issued, at a presumably lower value than paying tax on them when they vest. The caveat is they may not have cash for the tax liability. Conversely, they can pay taxes on income as shares vest, which could be at a higher value. It can make a significant financial difference for owners, and they have a short window in which to make the 83B election.
What about company valuation? VCs and founders often have a different opinion on valuation. At the company’s inception, founders need to look at valuation and equity, from a number of perspectives, both now and into the future, perhaps, five years out. Shareholder agreements should include guidance in the event of an exit. Will there be a put option or call option for founders who leave? Remember, buybacks can be expensive.
Are there other VC considerations with respect to owner equity? Because shares will get diluted when angels and VCs enter the picture, it again necessitates that owners look at both the journey and the destination. Investors want a return commensurate with their risk level. Thus, founders need to have a vision and a long-term commercial strategy. VCs may recognize company limitations (technology, sales, and marketing) unseen by owners. In this case, founders need to be knowledgeable about the business’ prospective cash needs and the impact future dilution may have on ownership amounts.

The conversation regrading founder’s equity is often overlooked or deferred while the focus is on making dozens of other, sometimes more exciting, startup decisions. Dividing founder’s equity sets an important tone. Talk it through. Make every effort to avoid the “let’s just shake on a number and move on” approach. In addition to the economic ramifications, don’t discount the emotional ones, particularly if the new company involves friends or family members.

Stockholders Agreement – Five Common Issues and How to Address Them

Author J. Andrew Robison Leave a Comment

Consider a routine scenario in advising business clients: two or more folks come to you with plans to start a company. Full of big dreams, plenty of optimism and the unshaking belief that nothing can go wrong, they ask you to advise on the critical issues of formation and capitalization. In addition to perhaps a dose of business reality, your clients (topic for another article) also need a document that governs the internal relationship between the owners of the new entity. The stockholders agreement (in the corporation context) or the limited liability company operating agreement (in the LLC context) serves this purpose and, when done properly, acts as a guide to the conduct of business throughout the life of the entity. The stockholders agreement is one of, if not the, most important documents to be discussed with your clients in the initial formation of a company. This article uses the terms “stockholders agreement” and “operating agreement” interchangeably and will focus on the use of such a document in the context of a corporation.

The stockholders agreement governs the internal operations of the company through transfer restrictions, governance provisions and exit mechanisms. One may encounter clients that do not see the value in spending time or money to think through and draft all of the various issues associated with stockholders agreements. There may exist compelling reasons for deciding not to enter into such agreements in individual cases. As a general matter, however, particular attention should be paid to those clients who choose to forego such an agreement. Anecdotal experience suggests that some of the most expensive and protracted battles between stockholders have occurred following a decision by such stockholders that they did not need a stockholders agreement. This article will consider five common issues that attorneys and clients encounter in the preparation of a stockholders agreement. This article will also offer for consideration potential solutions to address those issues.

Eligible Shareholders and Other Tax Issues

A stockholders agreement is often used to commit, from a contractual standpoint, the stockholders of an entity to preserve the desired tax nature of such entity. Stockholders agreements are found in both S-corporations and C-corporations, but take on particular importance in those corporations where the stockholders have decided to make an S-election.

A corporation must meet the following characteristics to qualify for S-corporation status:

Be a domestic corporation
Have only allowable shareholders
- May be individuals, certain trusts, and estates and
- May not be partnerships, corporations or non-resident alien shareholders
Have no more than 100 shareholders
Have only one class of stock
Not be an ineligible corporation (i.e. certain financial institutions, insurance companies, and domestic international sales corporations)

The stockholder agreement should contain provisions that require and maintain the “allowable” shareholder criteria. Failure to do so may prevent an S-election or cause the corporation to lose S-status.

Issue: The corporation needs to have the stockholder composition required to make and maintain an S-election.

Fix: Establish internal criteria for the admission of acceptable stockholders of an S-corporation and, in conjunction with the transfer prohibitions discussed below, to prevent transfers to any person or entity who or which would not qualify as an “allowable” shareholder.

Distribution Provisions

Stockholders in an S-corporation will receive pass-through tax treatment on the profits and losses of that corporation. A common issue that these stockholders face is whether they will receive distributions from the corporation in an amount sufficient to satisfy the tax obligations resulting from such pass-through treatment. With this issue, the needs of the stockholders can conflict with the capital or cash-flow needs of the corporation. The appropriate resolution of this issue will depend on the specific circumstances of the corporation and its stockholders. A common fix is to provide for a distribution in an amount not less than the taxes owed by the stockholders. The amount is often based on an estimate of the aggregate amount of the highest federal and state tax rates to be paid by a stockholder.

Issue: Stockholders may receive allocations of profits and losses and be taxed on those allocations without a corresponding amount of distributions necessary to satisfy those taxes.

Fix: If appropriate for the corporation and its stockholders, establish a minimum amount of distributions to be made. Consider further the timing of such distributions as many corporations make distributions quarterly or annually.

Transfer Mechanisms

For any entity that manages to stay in business, the stockholder roster of a corporation will evolve naturally over time. Individual stockholders may desire to engage in financial or estate planning involving the creation of entities to hold their stock or to ensure that the ownership stays within a family or other concentrated ownership group. An entity stockholder may experience changes in the composition of its ownership base. Any stockholder may receive an offer to purchase or sell stock that causes it to reconsider its investment objectives. In addition to the tax considerations of ownership transfer (see the S-election discussion above), the non-transferring owners will have a strong desire to maintain other owners who share common characteristics (a family relationship, investment perspective or the desired timing of holding may all factor into the decision-making of the non-transferring stockholders).

Issue: Some stockholders want and need some flexibility in the transferability and liquidity of an ownership position. Others want to avoid owning an entity with people they do not know.

Fix: For voluntary transfers, establish a mechanism where a stockholder desiring to sell stock to a third party must first go through a right of first refusal or offer process. This process would give the company and the other stockholders the first opportunity to purchase the stock that will otherwise be transferred. This will ensure that the company and the other stockholders have a right to maintain control over the ownership base. At the same time, it allows the stockholder desiring a transfer to reduce or eliminate ownership in an entity. In the case of involuntary transfers, create a process where the transferring stockholder is deemed to have offered the stock to the company and the other stockholders in advance of the event creating the involuntary transfer (divorce settlement, bankruptcy and death are common examples of triggering events). The stockholders agreement can also contain a “permitted transferee” concept where an owner has the ability to transfer the stock to a spouse or family members or entity created for such persons.

Governance and Voting

A corporation often has stockholders with classes of stock with negotiated rights and preferences. In addition, some stockholders may have rights not shared by other stockholders due to the percentage of stock owned or, in some cases, the timing of the stock purchase. A common right for many stockholders is the ability to cause other stockholders to vote for a proposal made by the first stockholder. The stockholder with this right wants to make sure that an extraordinary proposal, such as a plan to sell the company, will not be held up or face other execution risk due to a recalcitrant holder of a minority ownership stake. Stockholders may also want the right to commit the other stockholders to vote for such things as certain board member positions and the engagement of outside advisors.

Issue: A corporation often needs to allow a majority or dominant stockholder to take certain actions with the comfort and certainty that the stockholders agreement will compel the other stockholders to support those actions. The dominant stockholder also wants to eliminate the ability of a stockholder with a much smaller ownership stake to slow or stop a proposal supported by the dominant player.

Fix: Include a “drag-along” provision in the stockholders agreement. This provision will accomplish the aims of the dominant stockholder while limiting the rights of the smaller stockholder. This provision can also be used in negotiations with third parties to counter any concern about the ultimate ability of the first party to do a deal.

Dispute Resolution

The dispute resolution provisions in a stockholders agreement can often be overlooked as boilerplate and not worthy of sufficient time and attention. Certain aspects of these provisions, however, can make a major difference in the speed and ease in which stockholder disputes are settled. Establishing governing law and venue for the hearing of disputes at the outset of a business relationship can prevent a race to the courthouse and the cost and confusion of adjudicating multiple claims. In addition, the waiver of a jury trial may be an appropriate way to have a stockholder dispute considered by a court. Some stockholders agreements go further to require mediation or arbitration as a way to ensure that disputes are heard by a neutral who possesses certain characteristics such as educational background/training or industry knowledge.

Issue: Create a dispute resolution framework that is equitable to stockholders of a company who may possess disparate resources, business sophistication or access to the court system. Avoid a process that could tie up a company in expensive and protracted legal battles.

Fix: Have the stockholders agree on the following mechanics: (i) what will be heard; (ii) where will be it heard; (iii) who will hear it; and (iv) identification of the law to be applied. An agreement on these details should have the long-term effect of reducing frivolous claims while providing all stockholders with appropriate access to a dispute resolution process.

There are numerous other issues that bear discussion in the drafting of a stockholders agreement. Unfortunately, space limitations require that this article be limited to those herein. It is hoped that the stockholders guided by counsel who carefully consider the issues highlighted in this article as well as those other issues may find the time and resources well spent.

Biggest Lessons I Learned While Building Past Startups – Interview with Emanuel F. Barros

Author Joanna Jana Laznicka Leave a Comment

This is an interview with Emanuel F. Barros, a serial entrepreneur who has spent 30 years working in the technology sector. He began in software, computer peripherals and semiconductors, before moving onto NASA Ames Research Center in 1996 to work on flight hardware for space-based research on the space shuttle and now the space station. He left NASA in 2002 to work full-time in a previous startup, but returned to NASA 10 years later. NASA in 2012. Emanuel has started several startups over those years and is currently working on another startup with a co-founder also a NASA engineer called Quipist.com a social good platform.

Joanna: Emanuel, this article is primarily about lessons learned from your previous startup experiences. My readers are interested in learning about your process and how you integrate those lessons into subsequent startups. My questions will get to the heart of those lessons.

Emanuel: First of all, I’d like to thank you for this opportunity to talk about the knowledge I’ve acquired from my years of working in technology, research and startups. I’m happy to pass on any of my tidbits of wisdom and answer your questions the best I can.

Joanna: One of your past startups had tremendous potential. It had well thought-out products and in-demand services. Yet, it was unsuccessful. It failed due to a new team member and a misguided change in direction. Can you tell us more about this?

Emanuel: You’re referring to one of my previous startups, I was the visionary founder and technology developer with a great team and various investors who were financing the startup. We were at a point where we were well on our way to big success! Most importantly, we had customers ready to buy our products and services as fast as we could provide them. Of course, having customers equals revenue, equals achieving milestones that lead to success.

It’s the nature of startups to have subjective perceived risk, so the news of ready, waiting and paying customers stirred up the investors, prompting them to insist on hiring an MBA to replace me as the interim chief executive and take over managing the progress, leaving me to focus on the technology. Once he was onboard, he had a huge influence on the investors regarding finances. At the time I felt it was premature, but everyone else believed it was better to plan ahead and be prepared for the next level of success so I agreed. Overall it was a great plan, but unfortunately getting the right person onboard is also critical and tricky. A candidate can have great educational pedigree, look great on paper and even have an amazing rolodex of contacts. Unfortunately in our case, that person was missing one very important quality. Although he had great business credentials, he was not aligned with the vision and mission as the rest of the team: To deliver the product and services we had to the existing customers as quickly as possible. Instead delivery was delayed and the little capital we had, was spent on building up how the company looked to new investors by getting a bigger office etc. The result? Losing focus of what was already working. This can be deadly for a startup. Before we were out of the woods financially, we were bankrupt.

When success is in the palm of your hand, and it’s abruptly snatched away, it’s incredibly heartbreaking. This painful and unexpected lesson taught me that clear communication and documented buy-in by everyone involved is a must for the startup visionary. The assumption made by our team that someone else could be brought in to carry out our vision and mission accurately was a mistake. He did an excellent job selling his ability to make it happen for us, which didn’t work. Sometimes you need to listen to your gut and communicate firmly to the team.

In hindsight, I should have proposed a compromise. I should have insisted on completing the product build for our few customers before hiring an outsider. This example shows how critical it is to remain focused on the things that will start to generate revenue. No one imagined we could go bankrupt so quickly.

Joanna: How can other startups avoid the same mistakes?

Emanuel: The vastness of information passed around about startups can be daunting, misleading and confusing. What qualifies as a successful startup? What qualifies as a failure? Is there anything else other than a success or failure? The questions never end and they shouldn’t.

Unfortunately more than 90% of startups fail, even when they have a great product or service, great branding and paying customers. It just takes one team member who is not in alignment with the mission, vision and full dedication of the rest of the group. As the cliché goes, “there’s no ‘I’ in Team”. Having a team that works well together matters far more than anything else — I can’t stress that enough. Members on a startup team need to keep their egos in check, work seamlessly together and be completely committed despite setbacks. Bickering, second guessing or rehashing past setbacks only erodes team confidence. Thinking of the team as an organism that depends on all its parts to survive can be helpful. It’s all about the team and its commitment to succeed.

There’s also the long game and the short game. Success means something different with everyone. If you are a truly dedicated team player, you are in it for the long game. You’re thinking outside the box, and accepting mistakes as setbacks and an opportunity to learn, moving forward in a more productive way. The short game is about turning a quick profit. Short-game players fail easier from lack of dedication. They give up too fast, and lose confidence and focus after a single setback. True long-game players don’t give up. They are the entrepreneurs who understand it takes time and dedication to achieve lofty, but worthy goals. Profits are never the primary goal, but simply a positive side effect of executing and staying committed. The long game is about the mission, vision and the team. The short game is about greed.

It’s not as black and white as success or failure. The major victories are clear once startups have executed a successful exit strategy, but there are many other types of successes worth identifying. .Setbacks and loses happen, but a true entrepreneur never has a complete failure. If it’s impossible for you to see a failure as an opportunity to course correct or learn, entrepreneurship and startups may not be your game.

Joanna: What should founders of technology and engineering startups when considering outsourcing or hiring staff to manage financing or operations?

Emanuel: It’s important to focus on core competencies, which can mean outsourcing or delegating other parts of the business to new staff or third parties to manage the supplemental tasks of running a successful venture. It’s not how much or how little you hand over, it’s more about determining if the timing/person is right and the criticality of what is being outsourced. The leader always needs to know the macro view of every aspect of the company, especially the finances.

There is a difference between micromanaging team members vs. overseeing every aspect of the startup by communicating often and being engaged every step of the way. It is important that whomever is chosen to lead the team, whether it’s the visionary or someone trusted by the visionary, that they have or develop good management/leadership/communication skills and are capable of supporting the mission and vision.

Joanna: Who do you think should be managing finances?

Emanuel: If you’re on track to start revenue, then you want someone who is great at tracking every cent until you have incoming revenue. Skillsets and track records are more important than educational pedigree. Someone committed and honest, whom can stay focused and watch every penny, is best. Even better is someone who has experience and knowledge of startup finances. Priorities in a startup can be different from a company with consistent revenue.

Manage your books carefully and communicate budget issues, if any, with your team often. Most of all, prioritize your budget carefully every step of the way. The last thing the team wants to hear is that it overspent before reaching the next revenue milestone and that the startup is nearly bankrupt. Everyone on the founding team should always know where the company is financially. Setting expectations is important.

Joanna: What tips can you give other budding startups for vetting co-founders, board members, advisors and investors?

Emanuel: It’s not always the best pedigree and education that makes the best team players. I’ll take someone without an Ivy League education who is humble enough to work as a team player and execute the vision, versus someone who wants to impress you with their credentials before wrestling you in a different direction. Albeit, there are times when a change of direction is needed because things aren’t working, but if things are working and leading you to revenue, don’t change your focus.

I look for confidence, humility, loyalty, integrity and respect in the person I’ll be trusting and working closely with. Will they dedicate like the rest of the team? The best vetting is consulting their previous colleagues, to get a feel for their level of commitment and core competencies. Also, don’t hold past failures against them. Sometimes past failures are the best experiences to learn from. Instead ask about what happened and what they learned from it. That will give you a much better indication as to who they are.

Although a leader must see themselves as part of the team — having positive relationships with each team member — they also must have a neutrality that can help them make good objective decisions about potential hires. They should never add someone to the team simply because they like them or share common interests. A new team member should have the right qualifications and, of course, references and background checks should come back clear. I also look for automatic positive rapport with multiple interviewers over multiple days. Congruency with what the potential team member says and does. I also follow my gut. If everything seems right but I have a funny feeling, I listen carefully. Continuing with the theme of objectivity, the vetting process doesn’t end with the bringing on a team member congruency, reliability and performance over time is the true test. In a team you either succeed as a team or fail as a team.

Joanna: What is a “social good” startup? Why a “social good” startup this time around?

Emanuel: My current venture is about community and empowering that community to make positive change in the world with “social good” causes. I’ve reached a point where it’s more important to take actions that will bring about social good in a positive make-a-difference sort of way.

Recently I read Give and Take by Adam Grant, which was given to me by my co-founder in this new venture. This book aligns perfectly with who I am: It explains how people who give more than they take are much more successful in the long run. That being said, you want to be a giver and align yourself with other givers. Although we are a for-profit venture, it’s more important that we are aligned with making those social good goals a priority. Non-profits have a stigma attached to them. For many people, that word “non-profit” automatically equates to never-ending fundraising or professional panhandling. It means constant struggle and never enough budget. I believe that with the new world of high-tech/information age, it’s becoming much more possible to fund causes that give back to the community without the struggle attached to non-profits. I’ve been asked, ‘why don’t you just start a non-profit?’ I’ll answer that with, “Why struggle when you can run a for-profit and support your causes?” If you’re a giver and not greedy, it’s a no-brainer. Look at TOMS’ business model. Giving away a pair of shoes to a poor child for every pair of shoes sold is following that model exactly! More startups are doing this. I like what I see!

Joanna: To conclude, gleaning from all of your experience, what would you say is the most important lesson you’ve learned from your past and current startup?

Emanuel: I can’t emphasize enough the importance of frequent clear communication and developing and retaining good relationships with every team member. Good rapport, trust, respect and transparency for all, including the visionary/leader are a must. I am grateful I have this with my current team, especially my cofounder. If this isn’t possible, then maybe the personality of those team members aren’t a fit for your startup. Also have fun with your team! Get together regularly to do something social. It’s OK to be friends with your team. You’ll have much more trust and loyalty that way!

Lack of communication is a common mistake to make because it’s easy to assume that the team is automatically on the same page with the current short-term and long-term goals. Although that may have been the case every other time, it doesn’t mean it will be the case every time. George Bernard Shaw once said: “Communication is the illusion that it has taken place”.

Inevitable with a startup, there will be unpreventable and unforeseen obstacles that some team members might view as a failure. This is why the visionary/leader must get constant buy-in about short-term and long-term goals from every team member throughout the process. Frequently confirming everyone is on the same page is a way of getting back on track when obstacles appear. For instance, investors may become apprehensive if suddenly more money is needed for an unforeseen setback. A simple review of the recently discussed long-term goals will help them get onboard faster for the new short-term goals. If long-term goals haven’t been reviewed for months, individuals might have more difficulty remembering and getting on the same page. Had I been more firm with my communication with my previous startup, there would have been a much better outcome.

Joanna: Is there anything else you would like to add?

Emanuel: Team members need a thick skin when there’s outside criticism. There will be criticism, but remember that outsiders don’t know the mission and vision like the team does. Always stay united and back your team over outsiders. If you can see how outside criticism has affected your team, hold a debriefing meeting to address this. It will prevent resentment, bickering and teammates being at odds.

Don’t get stuck being overly cautious or a perfectionist. Attempting to perfect a product or service can cause the team to lose focus on getting to market. Startups must be agile. They must accomplish a huge amount quickly with minimal budgets.

I’ll conclude with my advice for aspiring successful entrepreneurs:

Follow your dreams, goals and gut. They will inspire you to succeed. Inspiration and dedication are everything!
Never commit to a venture solely for the money or greed. It’s become more difficult to get away with greed due to technology and transparency of the information age. You’re only a few searches away from the truth! Greed will only demonize you. Give it up permanently.
Always give more than you receive: That’s how real value is created. We don’t live in a zero sum world. Economies grow with inspired, innovative activity. Everyone loves to help givers.
Have and use mentors who you believe in and trust.
Work with people that inspire you and you inspire them. This kind of teamwork is priceless!
Understand why you are doing your venture. Then go tell the world what’s great about it.
If you don’t give up on your dreams and goals, you will succeed!
Always act with integrity, loyalty and transparency. .
PR and marketing are important to get your message out.
Don’t believe in magic, believe in yourself and the magic will happen.

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