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Making Sure a Company's Founders Are Diluted Fairly

Cliff Ennico on

"A couple of months ago I started a Web-based company with two college friends. We agreed that I would have 20% of the stock in this company, and that my two friends would split the remaining 80% equally (40% each). That is okay with me, because this is really going to be their company -- I'm just designing and putting together the social media Website for them, and I won't be involved in the business full-time.

"We hired an attorney to draft a Stockholders' Agreement for us, and he sent us a draft the other day. It's a 40 page monster with all sorts of provisions I don't understand.

"I really only have one concern. I don't mind owning only 20% of the company but I don't want my two friends to get a leg up on me and force me down to 1% or 2% once my work on the Website has been finished. If a new investor comes in and dilutes all of us, that's okay, but I want the three of us to always be 40/40/20.

"What are some of the things I should look for in the Stockholders' Agreement to make sure that doesn't happen?"

First of all, let me commend you on your fairness (or perhaps it is naivete) in agreeing to accept only 20% of this company. Most people in your situation would have taken the position that they are entitled to an equal share of the business because you are designing the website for a business that can't operate without one and, therefore, are indispensable to the company's future success. Since you are not planning to work in the business full-time, however, there is some justification for your having a less-than-equal share.

I would also point out that a 40/40/20 split puts you in the uncomfortable position of tiebreaker if your two friends ever disagree on something. No matter which way you vote, one of your friends will hate you. Think long and hard before stepping into that role.

But never mind.

My immediate response is that you shouldn't be looking for anything in the stockholder agreement. Your first task should be to hire an attorney of your own to review it for you and point out all the possible pitfalls. The lawyer the company hired is representing the company, not you or your two friends individually. Since it was presumably your two friends who hired the attorney and are paying his or her fees, this lawyer has no obligation to look out for your best interests. You need someone on your side who is looking out only for you.

Yes, it will cost you some money in legal fees (about two to three hours of an attorney's time, just to give you an idea of a fair fee), but it will help you sleep better at night and prevent just the sort of majority-versus-minority-shareholder shenanigans you are rightly worried about.

 

Having said that, here are some provisions you should insist on including in the agreement to make sure you are not treated unfairly.

Put Yourself on the Board. There are three of you, and all three should be on the board of directors. Your friends may not like this, as it gives you the deciding swing vote should they disagree on something, but it ensures they won't be able to do anything behind your back.

Require a Unanimous Stockholder Vote When the Company Issues New Shares. In most states, a company can do just about anything with the approval of a majority of the stockholders (i.e. your two friends). But if they're planning to issue stock to a new investor (or more stock to themselves), that should require the approval of all three stockholders, as you all will be diluted once he or she comes on board. This provision (a supermajority voting clause) gives you the ability to block any attempt by your friends to increase their ownership share at your expense.

Consider a Preemptive Right. If something happens that dilutes your ownership percentage below 20% (for example, the admission of a new stockholder), a preemptive right gives you the right to purchase additional shares of the company at a discounted price to bring your percentage back up to 20%.

In many states, you have to amend the company's certificate of incorporation to create preemptive rights -- merely including a provision in the stockholder agreement will not be enough legally.

Consider a Phantom Stock Arrangement. If your two friends will not agree to any of the above solutions, you can ask them to compensate you for your web development services in an amount equal to 20% of the company's pretax income each month regardless of the amount of stock you own. That won't prevent you from being diluted, but it guarantees you the same payout that a 20% stockholder would have. In a tough economy, cash beats stock any day.

Cliff Ennico (crennico@gmail.com) is a syndicated columnist, author and former host of the PBS television series "Money Hunt." This column is no substitute for legal, tax or financial advice, which can be furnished only by a qualified professional licensed in your state. To find out more about Cliff Ennico and other Creators Syndicate writers and cartoonists, visit our webpage at www.creators.com.

 

 

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