In the dynamic world of tech start-ups, the promise of success often hinges on equity participation for key employees, creating a potential minefield for those entering into arrangements linked to the growth of a company.
Here, Jack Bradley-Seddon and Mark Dawkins of Thaxted Capital draw on their experience as litigation solicitors turned litigation funders to help guide individuals, particularly co-founders and early-stage employees, on avoiding disputes before they arise.
“We have seen many disputes”
As litigation solicitors turned litigation funders, we have seen many disputes and witnessed numerous pitfalls that lead to conflicts amongst shareholders. We can therefore offer insights on latent risks that may have existed when early-stage employees first joined the company, thereby safeguarding their interests from the outset.
To ground our exploration, let’s consider the journey of an imaginary seasoned marketing professional looking to take on the role of chief marketing officer at a new tech start-up in the North. Whilst the salary on the table might be lower than expected, the offer of a generous share options scheme is enticing; the incumbent CEO and founder is dynamic and charismatic; and you are convinced that the company is destined for great things. You are very keen to be part of that success.
If things start to go wrong, what will an exit look like?
Although our CMO might not feel like it, now is exactly the time to take a cool-headed look at what would happen if things go wrong. It may sound negative, but contemplating what a potential exit for the CMO will look like when entering into such arrangements is essential. Unexpected events such as internal disagreements or leadership changes at the tech start-up could trigger unforeseen challenges. In this context, the CMO should have particular regard to the interaction between their employment contract and the share options scheme on offer.
Drawing from real-life scenarios, one unscrupulous tactic we have seen used on the employer side is to use this interaction to their advantage, claiming a “technical breach” of the employment contract, which can then lead to “bad leaver terms” and cause potential forfeiture of share options.
Against this background, our CMO might find themselves in inadvertent breach of a minor clause in the company expenses policy, such as not having formal written approval, which is then used as ammunition against them if and when things turn sour.
The disproportionate role of documents
Documentary diligence is paramount. Having been involved in many disputes over the years, it is clear that documents, including email, WhatsApp etc, take on a disproportionately important role compared with the role they would have had at the time that the share options scheme was being entered into.
This is because in the heat of a negotiated agreement, there are often many communications that are not recorded. These include meetings, phone calls and informal discussions, none of which creates a permanent written record of what happened or what was agreed.
When a judge is faced with a dispute, it is typically many years after the event (often the company needs to have had the time to become successful in order for the share options to be worth fighting over), and it is therefore difficult for witness testimony to be accurate and consistent in a way that can withstand cross-examination.
The bottom line therefore is that judges go for documents and so do many litigation funders.
The advice here for our CMO is to dot the ‘I’s and cross the ‘T’s and – given the critical importance of the documentary record – not to worry too much about being seen to be “nit-picking”. In short, make sure everything that could possibly be important is clearly documented.
Tax implications
Consideration of tax implications can be an interesting dynamic because the share options scheme would typically be designed and implemented by the tech start-up, as employer – and yet any drafting deficiencies that impact the tax position will affect the CMO, as employee. Our CMO should therefore seek early clarification on the tax treatment of share options. Ensuring correct implementation, documentation, and seeking expert advice before joining can prevent potential tax pitfalls down the line.
For our CMO, the time to bottom this out is before joining as that is the point of maximum leverage.
Timing
Timing of exercise is a very simple point that can easily be overlooked. Whilst there can sometimes be a natural gravitation towards a fixed time period such as 3 or 5 years, aligning the timing of share option exercises with exit events, i.e. when cash will actually be available, can be surprisingly important.
Mismatched timelines can strain a company’s cash flow. This is of course “on paper” an issue for the company but, if it affects the ability of the start-up to meet obligations, then we have seen what is the company’s issue on paper become the employee’s problem in practice.
By acknowledging this potential challenge early on, both the company and employee can strategize to avoid unnecessary financial strain.
Flexibility
In the fast-paced world of start-ups, flexibility in remuneration arrangements is key. Acknowledging the potential for pivots and changes in business dynamics, we would suggest our CMO builds in mechanisms for periodic reviews of share options.
We have seen things come to a head when a start-up really starts to take off – and some employees feel that the contribution that they have made is not adequately reflected in the arrangements that are in place.
Ensuring that arrangements are flexible, in order that they remain reflective of contributions, can go a long way towards fostering a fair and sustainable relationship between the company and its equity-linked employees.
Conclusion
Thaxted Capital encourages prospective tech start-up collaborators to proactively consider these key elements. By focusing on these aspects from the inception of a venture, individuals can navigate potential pitfalls and foster healthier relations, ultimately steering clear of disputes. As we navigate the complexities of the start-up landscape, let these insights be a guide to forging successful collaborations and achieving shared success.
