Preventing a Messy Business Divorce

Some of the messiest cap table problems we see didn't start at the financing—they started on day one, when co-founders were so excited to build that they never documented the basics.

Our rule: put the important pieces in writing as early as possible. Founder equity, vesting, intellectual property ownership, governance, and roles are much easier to agree on before the company has traction, investors, or meaningful value.

The TL;DR every startup founder should know before bringing on a co-founder to help avoid a messy business divorce:

1. Put every founder on a standard vesting schedule.

A four-year vesting schedule with a one-year cliff remains the market standard for venture-backed startups. Without vesting, a founder who leaves after only a few months may still retain a significant ownership stake despite no longer contributing to the business. Investors generally view large amounts of "dead equity" (sometimes referred to as "dead hand" ownership) as a cap table issue because it makes future hiring, fundraising, and acquisitions more difficult.

2. Assign all company IP to the company from the beginning.

Every founder should sign a properly drafted Confidential Information and Invention Assignment Agreement (CIIAA/PIIAA), or other appropriate intellectual property assignment agreement, so ownership of the company's technology, code, inventions, and other work product is clear. The last thing you want during financing or an acquisition is a former co-founder claiming, "I built it, so I own it."

3. Don't overlook employment law—even for co-founders.

If your startup is hiring founders or early employees, use properly drafted, state-compliant offer letters and employment documents rather than relying on generic internet templates. California, in particular, has unique wage-and-hour rules. If a California corporation engages a co-founder to perform services for the company (for example, as CEO, CTO, or COO), that individual will often be treated as an employee for purposes of California wage-and-hour laws unless a valid exemption applies. Although many early-stage startups defer founder salaries because of limited cash, doing so does not necessarily eliminate potential wage-and-hour obligations. Depending on the facts and the claims asserted, both the company and certain officers, directors, or other individuals may face potential liability for noncompliance.

4. Think about governance before your first disagreement—not after.

For two-founder companies, consider how major decisions will be made if the founders disagree. A company can experience deadlock at both the shareholder level and the board level. Whether it's accepting a term sheet, replacing a CEO, approving a sale of the company, or issuing additional equity, a 50/50 governance structure without a clear tie-breaking mechanism can leave the company unable to move forward at the worst possible time.

5. Build a mechanism to resolve deadlocks.

A 50/50 ownership split is common among founding teams, but it should be paired with thoughtful governance. Depending on the circumstances, founders may choose board structures with an independent director, contractual voting arrangements, reserved matters, buy-sell provisions, or other tie-breaking mechanisms. The right solution depends on the founders' relationship, long-term goals, and financing strategy, but every two-founder company should discuss how major disagreements will ultimately be resolved before they happen.

6. Include a dispute resolution process while everyone is still getting along.

Consider including mediation and, where appropriate, arbitration provisions in founder agreements or other governing documents. A well-designed dispute resolution process can often resolve disagreements more efficiently, preserve relationships, reduce litigation costs, and help keep sensitive business disputes out of the public spotlight whenever possible.

Founders spend countless hours perfecting their product, but many spend only a few minutes documenting the legal relationship with the people they're building it with. In our experience, that imbalance is responsible for some of the most expensive and preventable startup disputes we see.

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Transcript:

Lindsey S. Mignano:

One of the reasons why sales and raises can tank is cap table concerns with exited co-founders who never signed anything. let's talk about that. Let's talk about the things that we've seen sometimes companies make some mistakes on before they arrive at our desk, especially with regard to co-founders. And I think this arises, at least in my experience, it's more often with two. co-founder teams than three. But I'll turn it over to Ariana. What are the things that you see that maybe that, you know, could have just been done right the first time but weren't, and now we're kind of in trouble.

Ariana Shaffer:

Yeah, definitely. So I think if you hear nothing else today, it's get anything and everything in writing. It does not have to be a formal legal document to later than be enforceable in court, you know. it can be writing on the back of a napkin, you know, maybe invest in a a notebook or something. But if it's a napkin, that's fine too. And just write down the terms of your engagement really with your co-founder. And if that sounds too formal, really what it is how is equity divided? What's our vesting schedule? You both should be on a vesting schedule, right? Because things are great in the beginning, but what happens if a year in one of you has to leave either because things aren't going well or just for personal reasons? You want to make sure that that person doesn't just then walk away with, you know, 49% of the company. that down the road is really going to be hard for you to raise money because you'll have what's called like dead hand control on your cap table, which investors hate to see. And not to mention you'll have someone that has a bunch of equity that didn't earn it because they only stayed a year and you know, vesting typically is four years. So I would say in the beginning, when when you're excited about the company and you guys are on the same page, that's the time to say, okay, let's just do things the right way. Let's put ourselves on a standard four-year vesting schedule with a one-year cliff. Let's make sure we figure out the equity split. let's make sure that we assign the IP to the company so that if one of us leaves, the other one, that person can't say, but it's my IP. I built it. No, it the company owns it. Let's make sure, you know, if you're hiring employees early, that you have offer letters with clear terms that you clearly outline your expectations of their role and you know their vesting schedule as well. you know, there are state specific requirements for offer letters. So again, I wouldn't just go online and and Google offer letter and put that in front of someone, especially if you're in states like California or or New Jersey has has some interesting provisions as well. And so just again, make sure things are in in writing and really clear from the onset. ideally you talk to one of us, early, but if you don't, again, just make sure you have the the outline of how how things are going to be going forward for your company.

Lindsey S. Mignano:

Let's say it's a two-founder team. presumably they have their stock granted pursuant to a 4:1 vesting schedule. Presumably they've signed their CIIAAs or PIIAAs. And for anyone who doesn't know what that nomenclature means, it's a confidential or proprietary information inventions assignment agreement. It's usually in your online incorporation package. What other things might have to be cleaned up before we go for a raise or an acquisition?

Ariana Shaffer:

Yeah, so one thing you want to be careful about is having a deadlock on your board. so that can if it's early on and and there's two co-founders, typically you both would be on the board. And if you're splitting everything evenly and you each own 50% of the company, that means you each have 50% of the voting power before you bring on additional investors who might may or may not get a board seat. But then what happens if you all disagree? This is something that again, people aren't thinking about in the beginning when everything's going rosy, you just started a company, you're so excited to work together. But you know, six months down the road, you have to make a really tough decision on letting an employee go or shifting, you know, your direction or, you know, something related to customer acquisition and you just can't agree. When it's 50-50, it's really hard to then make a decision, you know? And so One thing we always stress is if you can, even if you're both gonna be CEOs or co-CEOs or, you know, one CEO, one's president, if you can have one person own even one percent more of the company. So a typical split we like to see is fifty one forty nine. And there's ways where you can economically still each have fifty/fifty on the equity, which Lindsey can talk a little bit about, but it really just protects you all. down the road from not being able to move forward with the company. I mean, worst, worst case would be you have a term sheet from an investor and one co-founder likes the investor and the other one doesn't. And you have 50-50, you know, split on voting and then what do you do? You know, you can't move forward because you can't get board approval. So it's that kind of stuff that you're not thinking about in the beginning, but really can be detrimental to your company pretty early on if if it's not thought about in the beginning.

Missed 83B Elections: Synthetic 83Bs

Founders: Missed your 83(b) election?

You're not alone—it's one of the most common startup equity mistakes we see as counsel. It usually happens in one of two ways: founders assume their incorporation platform handled the filing when it hadn't, or an early employee receives restricted stock, misses the 30-day deadline, and only realizes it once the company is gearing up for a venture financing.

Here's the hard part: unlike many other tax elections, the IRS provides essentially no practical late-filing relief for an 83(b) election. Once the 30-day deadline passes, a late election generally cannot be made.

The good news is that there may be ways to mitigate some of the tax consequences. Some startup tax practitioners refer to one such approach as a "synthetic 83(b) election."

It's not an actual IRS election. Instead, it generally involves restructuring the equity—for example, by modifying the company's repurchase rights or making other changes that eliminate the "substantial risk of forfeiture" under Section 83. If done properly, that can accelerate the taxable event so that future appreciation in the stock may be eligible for capital gain treatment, rather than continuing to be taxed as ordinary compensation income as the shares vest.

It's not a universal solution, and it won't undo tax that has already accrued. But many startup tax advisors view it as one potential mitigation strategy after the 83(b) deadline has been missed.

As with most tax planning, timing matters: the earlier the issue is identified and addressed, the greater the potential benefit. And of course, whether this approach is available or the best fit for you (over say, a Stock Cancellation Agreement based on non-payment for shares and subsequent re-issuance of shares) often depends on the specific facts related to the grant and should be evaluated with qualified tax counsel.

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Transcript:

Lindsey S. Mignano:

Hi everyone, Lindsey Mignano. So happy to be here today. I get to interview Jason Galek our senior tax lawyer here at the firm, on a topic that comes up quite often: missed 83B elections. And they usually get reported to us as a firm, as counsel for startups, at two different inflection points. Number one, A founder used an online incorporation service and assumed that the online incorporation service would take care of the 83B election submission. Some do, some don't. And it turns out maybe it just didn't this time. The other most common scenario that causes them to call counsel for their missed 83B elections is the company itself is going to go raise a venture capital round and Some of their early stage hires, maybe not even the founders, just early employees that they had hired back in the day, did receive restricted common stock pursuant to a vesting schedule, knew they had to file an 83B election, but just forgot. they didn't pay for their shares, they just completely forgot to turn in this 83B election. nine times out of ten, there is no share payment. It's simply just forgotten once the restricted stock agreement is signed and people are off to the races. So Those are the two inflection points. And you know, they kind of ask us, what can we do to fix this? And there is no 100% guaranteed fix in this scenario, but there is something called a synthetic 83B. And I wanted to elucidate that concept here on the podcast with Jason Galek because he's our resident go-to expert on all things corporate and individual tax. So, Jason, tell the folks why an 83B, you know, should not be missed. But if it is. what a synthetic 83 B election is and how it can kind of hedge, not solve, but hedge some of that risk of missing it.

Jason Galek:

Sure. Thank you, Lindsey. So the 83B election itself is limited to 30 days. If you don't make it within this 30 days, you are not able to make a late election. a lot of other elections underneath allow for late elections, but this is not one of them. So after that 30 days, you you're limited in what you can do. So the what many folks call the synthetic 83B election is it's really a mitigation tactic. So what you're essentially doing is you're creating a cost basis by essentially disqualifying your own shares from treatment under 83B. And by setting the cost basis, you're allowing the future growth of that value to be taxed at as a capital gain versus ordinary income. So it's better to do that earlier than later because you're really what you're trying to do is characterize the growth as capital versus setting the value, the cost. later, which is going to be an a measure of ordinary income. So you want to really do that sooner than later. one one just side note on the the synthetic the name of the synthetic election is that if you were to do a search on AI or Google, you might come up with what we've been discussing as a synthetic synthetic 83B election. But that can also mean Applying the same principles of 83B to partnerships using partnership income interests, which obviously is not what we're doing here. But there can be some ambiguity if you were just to do a quick search. So just recognize that it's not a term that's used consistently or uniformly. But what the way we've been using it, it's you're essentially doing the best you can with what you have to trigger the cost basis. So that more of your the growth of value can be treated as capital gain.