Over the years working as a Silicon Valley Startup Attorney I have seen far too many startups fail due to founder disputes.
For founders and early-stage employees, there is no true substitute for the benefits derived from properly drafted agreements regarding equity interests (stock purchase agreements) with appropriate measures of security in the event that the relationship simply doesn’t work out.
For such early-stage equity interest holders, having contractual terms that are both adequate and certain with respect to what happens to a founder’s stock in the event of a break-up is perhaps one of the most critical boxes to check before signing on the proverbial dotted line.
After all, let’s face it, relationships in early-stage companies (Startups) don’t always work out and unplanned exits are more common than not.
Unfortunately, what is perhaps equally if not more common, is the reliance by the founders on agreements that are not sufficiently tailored to their particular situation and expectations and thus ill-suited to their initial goals and intentions, which is of course the very thing that contracts are supposed to establish and preserve.
Among the most frequent of terms to be overlooked in such scenarios are those that ensure that if a founder departs a startup ‘without cause’ there is some basis upon which the startup founder may preserve some of their equity when it still remains subject to the startup’s rights of repurchase or what is otherwise known as unvested.
Where a person has potentially invested countless hours of time for little or perhaps even no pay, shares of stock can be tremendous and if those interests are unexpectedly lost, not because of anything the holder did in particular, but simply because a parting of the ways occurred and a standard ‘at will’ employment clause was invoked, the fallout can be devastating.
Typically, this risk is mitigated by ‘trigger’ clauses that are meant to ensure that if an equity interest holder is let go without cause incident to a liquidation event or other such fundraising or performance milestone that might present the temptation to deprive someone of their startup shares, then some or all of their unvested equity will have its vesting accelerated and thus no longer be subject to automatic rights of repurchase for pennies on the dollar.
But what happens when a founding shareholder is forced to leave their startup company before any such clause comes into play, or what if the controlling contract itself simply does not have any such provision?
Historically this would mean that the aggrieved founding shareholder was out of luck and, assuming that the startup company acted within the black letter of the contract, more likely than not left with nothing more than a highly questionable legal claim and a lot of ‘what-ifs’.
Now make no mistake, a loss of unvested founders shares without any rights of acceleration or other actionable protections still presents a daunting uphill battle for the departing founder.
However, developments in California cases over the last several years, coupled with certain longstanding principles, have begun to present a path by which such interest holders may successfully seek redress when their loss of stock or other interest is the result of malintent even if realized within the confines of what the stock purchase agreement permits.
In short, if a startup founder has a reasonable belief and can ultimately prove that his or her loss of unvested founder stock, was, while technically allowed under the provision of the stock purchase agreement, in actuality the result of an underlying intent to deprive the startup founder of their stock value which would not have otherwise been lost, the courts or other triers of fact may have a route to properly restore what was taken.
The line of cases that provide the framework for this path begins with actions addressing such ‘bad faith’ denials in the context of lost bonuses.
In DLSE v. Transpacific Transportation Company, 88 Cal.App.3d 823, 830 (1979), the Court opined that “the law does not support a forfeiture where the employees were terminated through no fault for their own after having substantially performed the services entitling them to a bonus.” (DLSE supra. at 830) Similarly, in Hill v. Kaiser, 130 Cal.App.3d 188, 191 (1982), the Court observed that “estoppel by conduct is a proper theory upon which to find entitlement to a bonus.” (Hill supra. at 191)).
Then in John Guz v. Bechtel National, Inc., 24 Cal.4th 317, FN 18 (2000) the California Supreme Court recognized that even where such lost interests including incentive-type compensation may be lost, it would be going too far to conclude that no situation could arise under which the depriving of such interests, even when contractually allowed, would not still be considered wrongful and thus subject to a viable cause of action and redress.
There, the Court noted that:
“We do not suggest the covenant of good faith and fair dealing has no function whatever in the interpretation and enforcement of employment contracts.
As indicated above, the covenant prevents a party from acting in bad faith to frustrate the contract’s actual benefits. Thus, for example, the covenant might be violated if termination of an at-will employee was a mere pretext to cheat the worker out of another contract benefit to which the employee was clearly entitled, such as compensation already earned….” (Guz supra, FN18)
The observation of the Court in Guz was consistent with earlier decisions of DLSE and Hill, where was clearly stated that termination without cause is not a sufficient basis for avoiding benefits of employment that were substantially earned and anticipated to be fully received upon the continuance of employment.
Analogous to these cases are a certain number of more recent holdings which, when taken together, make equally clear that termination based upon improper motivation can not only give rise to an actionable claim for wrongful termination but can result in the excusal of the condition of continued employment as a requirement for the receipt benefits including bonuses and vesting of granted stock options.
(See Newberger v. Rifkind, 28 Cal. App. 3d 1070 (1972); Kelly v. Stamps.com Inc., 38 Cal. Rptr. 3d 240, 252 (2005); Moncada v. West Coast Quartz Corp., 221 Cal. App. 4th 768, 797 (2013)).
Accordingly, while the best case scenario will almost always be properly safeguarded rights under the controlling stock purchase agreement itself, disenfranchised startup founder may now at least find some path away from what was once considered a doomsday scenario if indeed it does appear that their interests were terminated substantially for the purpose of depriving them of those same equity rights.
If you have any questions about your stock purchase agreement or your rights as a startup founder feel free to reach out for a free consultation with an experienced San Francisco attorney. To set up an appointment call or email.
