There is a question that most founders ask when organizing their startup companies in preparation for fundraising with the angel and venture capital community:
“Should I protect myself against getting fired from my position with the company? Maybe a severance payment clause or a clause accelerating the vesting of my stock if the VCs fire me without cause?”
After all, so the argument goes, it is the founder who is inviting the VCs to the party—it is the founder’s company, and it is the founder who spent years working in a garage on weekends and late nights putting together the magic that will guarantee the success of the startup.
Right at the outset, it should be noted that protective provisions like this favoring founders in venture-backed companies are definitely an exception to the general industry convention. In most startups—and I would conjecture on the order of more than 90 percent—there are no such protections.
Although this state of play in the startup arena might cause some anxiety for founders, here are a few factors that will shed some light on the subject:
• Investors usually seek to establish a level playing field in negotiating the general terms for an investment. Agreeing to protective provisions favoring a founder in the event things don’t work out, in the VC’s view, violates this goal. There is no guaranty to the investors that their investment will be successful, and there should be no guaranty to a founder in terms of severance or accelerated stock if the company’s board of directors determines that it needs to terminate the founder’s employment.
• Almost every VC will tell you that the caliber and experience of the management team are in the top mix of factors they evaluate in making a decision to invest in the company; and in some cases, this capability is the top factor and the only one they won’t compromise on. This means that if a VC or group of VCs represented on the board determines that a founder has to be let go, in their view, it is usually the result of a failed company. Not just a company that needs to “pivot” in response to the needs of the market or the customer or the dictates of the technology—but a company that regardless of the tweaks has no reasonable hope of success with that founder continuing in a management position. Replacing a founder is one of the few levers that investors can pull to breathe new life into a company, and they do it as a last resort.
• The founder’s goal of raising money starts, of course, with pitching a viable plan—a great management team, a market with a huge sucking sound, a disruptive or compelling technology or approach, an effective market strategy and a near-term prospect of hitting key benchmarks. But as any entrepreneur knows who has raised money from the VC community, establishing chemistry with the VC firm and particularly the partner who will be championing the startup to the firm’s partnership is equally important. For the founder to suddenly condition the relationship on the inclusion of protective terms if things don’t work out is a tough sell. It sours the chemistry, and it tilts the playing field in favor of the founder. It is like asking for a prenuptial agreement right in the middle of a courtship. That is not to say the question isn’t raised, but the founder shouldn’t be surprised if the investor doesn’t respond well.
At the end of the day, everything is leverage. For the founder who is fortunate enough to have several VCs courting the company with term sheets and promises of fame and glory, asking for protective provisions in the event things don’t go smoothly might turn out in the founder’s favor. But it shouldn’t come as a surprise if the investor declines the request.
Editor’s note: This post first appeared on Wharton’s Entrepreneurship Blog on Sept. 6, 2012.