“How a night in a five star hotel room cost me my company”
Well, I guess there are lots of stories that could flow from a headline like that. Most would be a lot more interesting than the post below. So I’ll keep it short.
The point is that founders can get themselves fired, and consequently lose all their shares. This post examines the mechanisms that would make that happen, and some examples of how this can work out in practice. Maybe, also, how to avoid it from happening in the first place.
It doesn’t occur often. Even so, managers and investors alike need to be aware of how the process works.
How the Articles of Association and the Director’s Service Contract could work together to rob the founders of their shares
On the face of it, there’s no relationship between a director’s employment agreement with SaaSco, and its Articles – a constitutional document regulating how shareholders interact to govern the Company. Separate parties. Separate agreements. Nothing in common. Except that:
- Firstly: SaaSco’s Articles stipulate (usually) that a founder may in certain circumstances lose some or all of their shares in the company if they leave SaaSco’s employment. There are lots of permutations but, in the extreme (being fired for gross misconduct say) the founder loses all their shares and gets nothing in return. See our post on leaver shares.
- Secondly: the typical service contract sets out in standard form the red lines which a founder (or any director or employee) must not cross which most of us understand intuitively – thou shalt not steal, that kind of stuff.
- Thirdly: sometimes, but not always, the investment agreement allows the investors to trigger the service contract clauses on behalf of the company if the board, for any reason, doesn’t. See our post on the relationship between investor, company and founder.
So, if SaaSco’s errant founder does the bad thing, then the board of directors activates the service contract clauses. If the directors don’t, then the investors might do so in any case. The founder is dismissed. The board consults the Articles and activates the relevant clauses. The founder is classified as a leaver. More particularly he is a bad leaver. He is sent a cheque for £1 and his share certificate is torn up. Everyone else owns a little bit more of SaaSco. All-in-all, everyone is likely a bit worse off, and slightly weary. But business goes on, and the remaining board and investors regroup, and get back to work.
So what’s this about the five star hotel room, then?
Ah yes. The clickbait….. Well, it could happen.
I led the IPO for a medtech in my investment banking days, which ultimately scaled and exited very successfully to a US quoted acquirer. At the point of our introduction, the venture investors had been rattled about the CEO’s personal expenses. Their Big-4 auditors had raised the issue, and got themselves hired to run a review. We ran through all their findings, and at the end of the process took the view that, if a founder has to spend a month in Tokyo, then it’s not a crime to expense flowers for their partner back in the UK (zero brownie-points for romance, however). So we took the view that the audit partner was desperately unworldly to the point of being prissy, and that there was nothing to see here. Oh, and we also got the audit moved.
The point was that the dispute had been escalating and if we hadn’t intermediated, investors and funder were heading for a fall-out about a triviality. It could have ended the founder’s employment and lost him his shares – and at the same time blown the IPO and lost the investors a valuable exit. If there was blame, then in my book suspect number one was the auditor for stirring up trouble unnecessarily. That said, the founder-CEO could so easily have avoided the problem by discussing his situation and getting empathy and buy-in from the board before getting out his company MasterCard. It’s all about communication.
In another instance, the founder team of a private equity backed company ended up in a court battle with their backers over the bonuses that they had paid themselves based on management accounts which ultimately proved to be overstated. They won their case. It could easily have gone the other way in which case, future bonuses and salary, their employment, and the sweet-equity shareholdings were all down the drain. And for what? Just to max out one year’s income? Was this a risk worth taking?
And then there’s the instance we mentioned earlier in the series of a co-founder who set up his own side-hustle to syphon-off business from his own company. That was out-and-out theft, so he was dismissed under his service contract, the leaver clauses kicked in, and he lost all his shares. All very mechanical. All very sad.
I’m conscious that the subject of these posts and the tales from the crypt are often slightly bleak. For sure, they reflect only a minority of investments, and they’re not cited to alarm either founders or investors. But the point is to be aware of your respective strengths or vulnerabilities under the investment agreements, and how these problems can arise: what needs to be negotiated ahead of time, and what needs to be documented. But most importantly – the importance of ongoing communication between founders and investors.
That’s all from us about directors’ service contracts. There is simply nothing more to say. So …… time to think of a new and entirely fun topic about the world of venture capital investing.
Partner, DSW Ventures
About DSW Ventures
DSW Ventures made its first investment in 2018 and is an investor in early-stage scale-up businesses requiring venture funding of more than £250,000, primarily on an EIS basis. It is funded by a growing network of high-net-worth investors. DSW Ventures is a trading style of DSW Venture Capital LLP, part of the Dow Schofield Watts Group.
DSW Ventures is a partner in British Business Investments’ £100m Regional Angels Programme, designed to help reduce regional imbalances in access to early stage equity finance for smaller businesses across the UK. British Business Investments is a wholly-owned commercial subsidiary of the British Business Bank, the UK government’s economic development bank.
Dow Schofield Watts is a UK independent advisory and investment group, headquartered in Warrington, Cheshire and with offices in Manchester, Leeds, Aberdeen, and London.
British Business Investments is a commercial subsidiary of the British Business Bank. Its role is to increase the overall supply and diversity of finance – both product and provider – on offer to UK smaller businesses. It does this while providing value for money for UK taxpayers. British Business Investments does not finance small businesses directly, but instead works with the market to provide funding through its delivery partners. These partners offer a range of funding options for small and high-growth businesses across sectors, regions and business stages.