Founder-Proofing Your Company

Written by Charlotte Kelso 
JD Candidate 2024 | UCalgary Law

In early 1999, Sean Parker and Shawn Fanning were busy starting one of the world's pioneering online music platforms which later became known as Napster. Sean and Shawn were both newly minted entrepreneurs in their early 20's so when Shawn's uncle, John Fanning, volunteered to support them as a co-founder of Napster, they accepted. John incorporated Napster and gave himself a whopping 70% of the company (despite having contributed nothing and his primary future contribution being his "credibility"). John's entrepreneurial history of dubious financial practices and unpaid loans bode poorly for Napster. As a founder, John contaminated the company with poor decision-making and drove away or vetoed potential investments all while failing to make any real contribution to the company.[1]
 
Napster's issues with respect to John are not unique. Start ups suffer at the hands of a founder all the time. The solution? Founder-proofing.
 
Founder-proofing is a blanket term referring to the assortment of steps founders can - and should - take to protect their business from themselves. But why would a firm need protection from the very people who brought it to life? Founders can become unnecessary, unhelpful, or even hostile to a venture. Unfortunately there is no crystal ball through which to foresee such issues and therein lies the value of founder-proofing.
 
A key characteristic of a founder-proof company is that founders are not permanent fixtures of the company. Potential investments - the lifeblood of a start up - can hinge on changes to the company's management team which sometimes makes funding contingent on ousting a founder. Founders who are not contributing or who are actively unhelpful or hostile to the company should not benefit from entrenchment.
 
There is a variety of corporate documents that could theoretically serve to entrench a founder, including the by-laws, shareholders' agreements, and founders' agreements. These documents should be drafted carefully with legal oversight to confirm founder-proofing is in place. Some red flags that may indicate a company's documents have entrenched the founders include founder employment agreements with high severance requirements and shareholders' agreements that give the founders veto power over basic decisions of the corporation, including hiring and firing of senior directors.
 
Conversely, a lack of appropriate documentation could also have the inadvertent effect of entrenching a founder depending on the circumstances.
 
Another cornerstone of founder-proofing is to moderate the power given to a founder. An over-saturation of power in the hands of the founders can result in the founder's interests and ideas being prioritized over those of the company and its stakeholders. One strategy to better distribute power in a company is to establish a well-balanced board of directors who meets regularly. Ideally, the balance of power on the board will be held by independent directors with representation from the founders and the most significant outside directors.[2] A red flag that may indicate a power imbalance is a class of superior voting shares distributed only to the founders.
 
As a founder, it may be uncomfortable to implement measures to protect the firm from yourself. However, a company's ultimate purpose is arguably to return dividends to its shareholders, not to protect the interests of its founders. For the sake of the company, implementing founder-proofing is a valuable step in setting up corporate governance.
 
 

[1] Menn, Joseph. All the Rave: The Rise and Fall of Shawn Fanning’s Napster. New York, Crown Business, 2003.
[2] Tingle, B. C.  Start-Up and growth companies in Canada - a guide to legal and business practice (3rd ed.). LexisNexis Canada Inc.