The next shoe to drop: founder divorces triggered by pandemic times

October 2020  |  SPECIAL REPORT: BANKRUPTCY & RESTRUCTURING

Financier Worldwide Magazine

October 2020 Issue

The turmoil brought on by the coronavirus (COVID-19) pandemic has stretched many technology and life science startups past the limit, and founder divorces are on the rise.

Breakups hurt – both financially and emotionally – in both business and in marriage. Just as sociologists have predicted spikes in marital divorce rates, there is now a noticeable increase in disputes and disagreements in startup board rooms and C-suites. Well-funded and even venture-backed startups are no exception. In this article, we refer to ‘founder divorce’ as a separation between a startup and one of the founders, both of the founders, the C-suite or a director at the behest of investors, one of the other founders, the management team or the board.

Since the first case of coronavirus was found in the US on 20 January 2020, the pandemic has had clear and significant implications for businesses, large and small, across the country. As we move deeper through the cycle of pandemic and recovery, the other shoe has dropped, and startup executives, directors and investors are having to come to terms with a significant increase in ‘founder divorces’ in 2020, and likely beyond.

A business divorce is one of the most painful events anyone can experience. A founder divorce has the extra emotion brought on by years of sweating for equity in a startup. From the outsider’s perspective, it is ‘just business’, but a founder divorce often creates just as much emotional drama as a divorce between spouses. Similar to a marital dissolution, a founder divorce is sure to boil over from overheated egos, emotions, accusations and expensive legal fees.

Often, when it is all said and done, in a founder divorce, the divided parts equal less than the pre-divorce whole. No matter how well documented the founders’ business relationship is, a founder divorce can still be nasty and expensive as parties look for loopholes in employment agreements, voting agreements, charters, protective provisions, bylaws and option plans. We have seen some founders pointing the finger at each other, citing the other’s incapacity, absenteeism, irresponsibility, lack of engagement, financial irregularities and more.

Today, venture capital firms play a pivotal role during times of economic stress by buttressing the stability of a startup with equity or debt funding and providing sage advice. In ‘startupland’, venture capital investors are especially vulnerable to losses from founder divorces. It would be smart for venture capital firms to take a look at their portfolio, be watchful for simmering tensions among founders and the C-suite and anticipate some hard decisions to protect the future.

While public companies tend to have diversified investor and owner bases with a clear corporate structure and chain of command to address business challenges, many startups do not. Instead, many startups have two or more co-founders or C-suite members and one or two venture capital investors represented on their board and in their capital structure. While startups face the same challenging economic environment and business interruption resulting from COVID-19 as public companies, they operate through an opaque governance system where decision making is distributed.

During the current COVID-19 pandemic, tech and life science companies and their venture capitalists may need to respond drastically when business is burning more cash and on a shorter runway that is sustainable. The current crisis and required responses can be the subject of real disagreement among founders, directors and investors. It may also affect how owners resolve them. Some will seek to sell shares, push out a chief executive or a founder, while others may invoke dispute resolution procedures and pursue relief under the shareholder and founder documents. We are seeing an increasing number of situations where the founders or their venture capital investors find that business divorce is the their only viable option.

In some instances, it is the unforeseen economic ‘shock’ triggered by the pandemic or its response in a given industry, and in other instances it is stress, interpersonal clashes and cultural dissimilarities, that are primarily to blame for many breakups.

Startups are facing all sorts of unprecedent challenges, including: (i) demand for products may have fallen; (ii) supply shortages and delays are affecting companies resulting in scarcity and higher costs; (iii) disagreements about employees that are currently not needed and salaries that are no longer affordable; (iv) commercial real estate space that is vacant but where lease payments are accruing, with businesses unable to fulfil contracts; (vi) fixed costs that will remain due; and (vii) cash needs that may have changed significantly.

At the onset of COVID-19, lawyers spent time advising startups on how to terminate contracts and deals that no longer made sense in light of the pandemic. Was there a force majeure clause that provided an exit? Was there frustration of purpose? Was the contract rendered impossible to perform? Had a counterparty suffered a ‘material adverse change’? Was management deadlocked? Could judicial dissolution be forced? Although these are extraordinary times, there is no one-size-fits-all answer.

Founders, management teams, boards of directors and investors will not likely find a separation ‘equitable’ and should take extra care of their relationships with one another to avoid a conflict from driving a startup over a cliff.

If the point of no return has been crossed, having mature, experienced and professional counsel can help map out the separation quickly and cleanly.

Louis Lehot is the founder of L2 Counsel. He can be contacted on +1 (650) 796 7280 or by email: louis.lehot@l2counsel.com.

© Financier Worldwide

BY

Louis Lehot

L2 Counsel

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