Your Business Deserves To Thrive

Co-Founder Agreements

On Behalf of | May 22, 2017 | Business Management

R. Shawn McBride recently interviewed Anastasia Button about setting up co-founder agreements. Here is the transcript:

Ms. Button:     Are we live? (laughs)

R. Shawn McBride:  We are live. Hey everybody, I’m Shawn McBride, live here. I’ve got my friend Anastasia Button here with me. We’re going to be talking about setting up your agreements, co-founder agreements, making things really work in your business. It was a topic she kind of brought to me and something I’ve worked a lot with over the years. So, I said, “Yes, let’s spend some time talking about a little bit of it.” Let’s get into some details. Tell everyone a little bit about you, and what happens in your world, just so they know who you are.

Ms. Button:  (laughs)

R. Shawn McBride:  What’s going on?

Ms. Button:  Well I live in Denver, Colorado and I am a millennial. They call me, “The millennial girl.” I deal a lot with companies and helping them with their millennial questions. But now, looks like I’m going to a startup, where I’m going to be teaming up with a boomer. His name is Brook Chestnut. The boomer and millennial are going to come into the workforce, and we’re going to help companies understand the multi-generations in the workforce to be productive, efficient, and to lower their turnover rates.

With that, I have a lot of questions when it comes to the legal stand point on the co-founders because it’s me and Brook. But, eventually we also want to have another equity partner to come on board, who has the cash, and has the connections into those big wig corporation kind of lifestyles. That’s where I’m coming at.

What do you even have to start thinking about when it comes to the agreements between co-founders?

R. Shawn McBride:  Right. Your issue is very common. This comes up a lot over the years. People come to us and ask us, “Oh how do we set these things up?” It has been something I’ve done a lot with over the years. I can definitely give you some thoughts. I think you and I can talk beforehand to let everyone else know that we’re not going to be talking about your legal details here really. We’re just going to just generally talk about co-founder agreements and what they look like. We’ll get into some of the other details, some other situation.

For the people who are wondering… one thing I always start with is, as I came through this over the years, I started coming up with ways to conceptualize and a checklist type thing. The first thing I tell people to look for is what I call the four D’s in the company: Death, disability, divorce, and disagreement. They are all downers, right? The four D’s are four downers. But, you want to be looking at those items anytime you have a partnership coming together.

What is going to evolve in the event that one of the partners dies, or one the owners die. If it passes to their estate or to other people, somethings might change in the business. You’re going to have a significantly different business.

What happens if somebody gets disabled? Well that person that’s disabled has to . . .  if it’s a long term disability, they’re going to have income needs and they are going to want their wealth from the business. But, the business has to replace their work, carry on, and has the needs of the other owners. You need to have a plan in place for that.

Ms. Button:  Yes.

R. Shawn McBride:  Divorce. Well sometimes one of the owners will get married and then get a divorce. Their spouse might become part owner of the business, and that’s a situation you want to keep an eye on. What happens if a divorce happens? How are the dynamics of the business going to change?

Ms. Button:  Yes.

R. Shawn McBride:  And the fourth D is disagreement. There’s a lot of things that bring up disagreement. I think it is unrealistic to think a partnership is going to last forever. You might have one that lasts a long term, and I’ve had partners that have been in business with each other for 30 years and that worked, with updating their documents and things like that. Some partnerships can last a very long time, and that’s good, but, not every partnership will. You need to be realistic. Your life is going to change and partners may make a decision to go a different direction at different times.

Those are kind of the surface things I always touch upon when I hit one of these situations. Then we get into other details like, dividing the economics, how do different partners play together. You talk about having a financial investor come in at some point in your businesses.

Ms. Button:  Yes. This year, Brook and I are going to be building, but eventually in 2018, we want to bring a third party on board to have that 33% share between all three of us-

R. Shawn McBride:  Right.

Ms. Button:  That person is going to bring a load of cash, but also the connections that we need, because Brook and I, we can bring in some cash, some stake-

R. Shawn McBride:  Yes.

Ms. Button:  But, at the same time, we don’t have those connections. That’s who we’re looking for. So, how would we make an addendum on that?

R. Shawn McBride:  Yes. What most people will do . . . you start a company when you found your business, either a corporation or more likely an LLC. The state will have that fundamental company there. That company would start its legal existence, having owners, assets, and liabilities, and building the business. All the business will flow through this limited liability company or corporation. Then what typically happens is that company authorizes the new owner to come in. So, you amend the documents and you update them to bring in the additional owner. If you’re talking about, it’s a common scenario of a common 50/50 owners, you bring in a third owner to be a third party, or 1/3rd owner and a third partner; you would amend the documents. The two existing owners would agree to the amendment, then you have a new liability company agreement, or you’d update your corporate documents to show all three owners in the business.

It’s a very common thing. Depending on how that investor comes in and what his needs are, they’ll ask for different things. They may be happy to sign your current agreement and become a 1/3rd partner, or they may ask for certain conditions or terms that they want in order to make their investment.

Ms. Button:  Right. Okay. Got you. So, when you do that shift, the question comes in… I’ve had this with Brook because he’s almost 60 years old and I’m almost 30. We are on very different paths in our lives in a sense. He’s kind of slowing down and I’m speeding up. When it comes to somebody wanting to leave, is that also something that happens in that agreement?

R. Shawn McBride:  Right. That is the best time to contemplate it. It’s in your agreement when you set it up in the beginning. You really want to be looking forward to the fact that you may have partners coming and going. You want a way to do it.

The worst case scenario is to not plan on a partner leaving and then have someone that wants to leave. Because now you have a problem, because you have to figure out what a buyout looks like. The LLC statures and the various estates really don’t deal with very articulately with this. They say you can enter or exit people from the business as you evolve, that’s okay. But, if you don’t have a mechanism in place, it’s very hard. We’ve seen unfortunately, business partnerships where people have ended up in the court house fighting over the value and they are wasting all their money on attorney’s fees. That’s the last thing you want to do as a business.

Ms. Button:  Right.

R. Shawn McBride:  What we’ll typically do with a lot of our clients is we come up with a mechanism to enter or exit partners. Part of that mechanism typically has some valuation methodology in it. You have to agree to some system before you’re ready to have a partner leave, to determine the value of what that partnership is. It could be formulas, it could be a third party evaluation person, then sometimes we’ll do some type of bidding system, where one partner will say the company is worth a million dollars and the other partner decides whether they are the buy or the seller at that valuation. It really encourages that first partner to set the valuation, to set a fair value. Because they don’t know whether they are going to be the buyer or the seller.

We use that kind of provision with a number of partnerships. But the key is you want to set a mechanism in the beginning that realistically understands that partners may come and go. It has some way to set a value without having to have a future agreement about the value. If you get into a situation where the partners one is leaving, they’re in a disagreement, something’s happening in the partnership, it’s not a good time to sit down and agree on what the business is worth.

Ms. Button:  Right.

R. Shawn McBride:  You want to have that agreement in advance.

Ms. Button:  Absolutely. To play off of that, another scenario that Brook and I have been talking about is more like a retirement plan for him. We were thinking maybe instead of him leaving the company entirely and buying him out, what would happen because I know he’s going to get bored when he retires and he going to want to come back for a little bit and do some stuff. So, with that, maybe we could shift him from whatever title he has in the company to more of that founder’s status, so he can still get some of that cash flow, you know what I mean?

R. Shawn McBride:  So-

Ms. Button:  Is that also something we need to put in that foundation?

R. Shawn McBride:  Yes. Probably something you want to build in there early on. You’re going to understand what that’s going to look like. The more that you can get the partner of the business talking early on and agreeing about what the business is going to look like, what the business is going to evolve into. The more you can plan for these scenarios and the more you can allow yourself to have flexibility.

What you’re talking about is, you have 50/50 partners but at some point you may be putting in different amounts of time and effort for the business. You may evolve from being that side by side partner, where you’re both putting in time and money in the beginning, to being partners where one of you is more of a financial investor and one of you is more of a day to day operator. We see that and we’ll often do this in situations like this . . .  we’ll build something into the agreement that allows for payments for time expended or for effort put in to the business. Then a division of profit after that. That creates a more fair mechanism to recognize the time contributions of the one partner that might be putting more time into the business. That allows both of the partners or the number of partners that are involved in the business to share the rest of the economic wealth.

These types of provisions can be very easily built into the partnership agreement, if you think ahead and get them in there ahead of time.

Ms. Button:  Okay, got you. When it also comes to the legal status of starting this business… it’s kind of off topic, when it comes to the founding stuff-

R. Shawn McBride:  Sure.

Ms. Button:  I know we were going to sit down with an accountant as well. But when it comes the LLC, the S corp, or the C corp-

R. Shawn McBride:  Yes.

Ms. Button:  Would you suggest starting small and growing big or kind of know where you’re going and start in that status?

R. Shawn McBride:  I think it’s important to know where you’re going. That’s one of the first questions I’ll ask my clients is, “Where are you going?” Part of it is timeline, and realistic and immediate expectation. A lot of times it might be great to be a corporation if you’re going to go public, but that might not be realistic when you’re starting your business. You may want to start as an LLC. If you have the kind of thing where you think you’re going to have a huge influx of cash and you may be exiting quickly, maybe you do form a corporation in the beginning. If it’s more of a steady timeline, where the business is going to build over time, you may want the simplicity of an LLC and the ability to build things over time. You really got to look at the overall situation and figure out what makes sense.

It’s easier today than it has been in the past, to move entities from one type to another. It used to be more of a difficult exercise. Most of the states have jumped on board and allowed us to easily transition companies between one entity and another. We can start out somebody as an LLC and most states, by filing a conversion, we can just change that LLC to a corporation. We use to have to go through a lot rigors forming a new company, doing a merger and all this kind of stuff. Now, they just allow us to move that company from one status to another, so that’s made it easier for people to move around.

Look at your long term vision, figure out where you want to go, and how quickly you want to get there. Then, figure out the realistic steps to get there. You may not want to start with the XTD, it’s a longer timeline.

Ms. Button:  Right, okay. Well this was great. Thank you. I really got a lot of my questions answered. I don’t have any more to answer-

R. Shawn McBride:  Okay.

Ms. Button:  Do you have any other advice that maybe you could put out there?

R. Shawn McBride:  I think the more you talk with your partner, the better. Sounds like you’re already well engaged in that process. That’s something I would tell people, just have a long discussion, and get as much of it in writing as you can. I’m not talking about writing your LLC agreement necessarily, that’s probably something you want to hand over to a lawyer. But, do sit down with a white board or a piece of paper, a word document, or whatever you want to use, and agree with your partner. I’m going to do this, you’re going to do that, these are our core functions. This is how we’re going to divide profits. This is what we’re going to do if we decide to part ways in the future. The more of that you sit down and put in writing and know in the beginning, the easier it is for your lawyer to draft. It keeps your legal fees down, you’ll end up with a better agreement and you’re going to have a better partnership. The more you discuss this stuff and understand each other, the more successful that partnership is going to work because you’re going to build that foundation of trust, understanding, and respect for each other.

Sounds like you’re off to a great start from what I’ve heard. You’re asking the right questions and thinking about this stuff. Just really put it down with your partner, talk about how it’s going to work, and talk about some of the tough things that a lot of people don’t want to avoid. Those are the things that can make a big difference for the business in the future.

Ms. Button:  Yes, absolutely. Well thank you so much, Shawn. This was brilliant. I really appreciate everything.

R. Shawn McBride:  Thank you. I appreciate you stopping and asking me some questions because it’s always helpful to get this out there. I hope it helps some other people that are starting their business.

Ms. Button:  I’ll be sharing this like a mad woman. (laughs)

R. Shawn McBride:  Well thank you for being here today, and I’m looking forward to talking to you soon. I’ll see you in a couple of weeks out in Denver.

Ms. Button:  Absolutely, all right. Shawn, thank you so much. Bye bye.

R. Shawn McBride:  All right. Great talking to everybody. Talk to you later. Bye.

Each case is unique.  Past results do not guarantee future outcomes. This posting is intended to be a tool to familiarize readers with some of the issues discussed herein.  This is not meant to be a comprehensive discussion and additional details should be discussed with your attorneys, accountants, consultants, bankers and other business planners who can provide advice for your circumstances. Each case is unique.  Past results do not guarantee future outcomes. This article should not be treated as legal advice to any person or entity. FreeImages Photographer Tom Albrighton.

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