Co-Founder Disputes: Exits, Vesting and Deadlock

What should you do first when co-founders fall out?

Stop and read before you act. Collect the shareholders' agreement, the articles of association as filed with the ROC, any founders' agreement or term sheet, each founder's employment or consultancy agreement, any IP assignment, the bank mandate and the last few sets of board minutes. Most of the answers are in those papers, and so are most of the traps.

Then secure what can be lost, without escalating. Make sure the company's code repositories, domain, cloud accounts and customer data are under company-controlled accounts with more than one administrator, and take copies of key records. Do not change passwords to lock a co-founder out of systems he or she is entitled to use as a director, do not stop his salary without a contractual basis, and do not move money. Self-help taken in anger is the single most common reason a founder with a good case ends up defending an oppression petition.

In co-founder disputes that reach Advocate B.K. Singh's office, the documents that decide the first few weeks are rarely the shareholders' agreement. They are the bank mandate, the IP assignment and the email trail, because those decide who can keep the business running while the bigger questions are argued.

What do your documents actually say?

Look for five things. First, vesting: are the founders' shares subject to vesting, and if so, over what period, with what cliff, and what happens to unvested shares on departure? Second, leaver terms: is there a definition of good leaver and bad leaver, and a price for each? Third, transfer restrictions: can a departing founder sell to an outsider, or must he first offer the shares to the others? Fourth, deadlock: is there a defined mechanism, and has it been triggered? Fifth, dispute resolution: is there an arbitration clause, and where is the seat?

Then check whether those terms are in the articles too. A vesting or compulsory transfer clause that appears only in an unstamped shareholders' agreement, and never made it into the articles, is much harder to enforce against a reluctant founder. The board may have no power under the articles to register a transfer the founder refuses to sign.

Many early startups have none of these documents. Two founders incorporated with model articles, split the shares 50:50 and agreed everything else orally. In that case the default rules of the Companies Act apply: each founder keeps his shares whatever he does, can be removed as director only by a shareholders' vote, and can block any special resolution with more than 25%. That is not hopeless, but it means the exit has to be negotiated rather than enforced.

Common co-founder situations and where they usually go

This is the usual pattern. The documents in each case can change the answer.

How does founder vesting work in an Indian company?

Indian company law does not have a concept of shares that 'vest' over time once issued. A share is either allotted to you or not. So founder vesting in India is usually done as reverse vesting: each founder is allotted all of his shares at the start, and the shareholders' agreement and articles provide that if he leaves before a date, a portion of those shares, the unvested portion, must be transferred to the other founders, a nominee or an employee trust at a nominal price, often face value.

A typical schedule runs over four years with a one-year cliff: nothing vests if the founder leaves in the first twelve months, a quarter vests at the end of year one, and the rest vests monthly or quarterly after that. Acceleration clauses can vest some or all shares on a sale of the company, or if a founder is removed without cause. All of this is contract, so the precise words decide what happens.

Enforcing it needs a mechanism. The departing founder must sign a share transfer form or give demat instructions, and many will not. A well-drafted agreement gives the board or a named director power to execute the transfer on his behalf, and the articles let the company register it. Even then, expect the founder to argue that he was a good leaver, that the clause is a penalty, or that the company itself breached first.

Tax is the hidden cost. Where unlisted shares are transferred below their fair market value, the income-tax law can tax the buyer on the difference and deem the seller to have sold at fair value. A transfer of unvested shares at face value in a company that has since raised money at a high valuation can therefore produce a tax bill for both sides. Plan the vesting structure with this in mind, and price any compulsory transfer with your chartered accountant before it is triggered.

Good leaver or bad leaver: who decides?

The agreement decides, and the definitions are what people fight over. A good leaver is usually someone who leaves because of death, disability, termination without cause, or after a set number of years. A bad leaver is usually someone who resigns early, is dismissed for cause such as fraud or serious breach, or joins a competitor. Good leavers typically sell their vested shares at fair value; bad leavers may have to sell all their shares, vested or not, at the lower of cost and fair value.

Expect the departing founder to dispute the label. A founder labelled a bad leaver for 'cause' will ask what the cause was, whether he was given notice and a chance to answer, and whether the board that decided it was properly constituted. A founder who resigned will say he was forced out by the others' conduct, which some agreements treat as constructive termination and therefore good leaver.

If you are the remaining founders, build the record before you rely on bad leaver terms: written notice of the breach, a chance to respond, a board meeting held with proper notice under Section 173, and a reasoned resolution. If you are the departing founder, do not resign in a single angry email; first get advice on how the agreement classifies a resignation and whether something else, such as a negotiated exit, will leave you with more.

Can a co-founder be removed from the company?

A co-founder can be removed as a director, and as an employee, but not as a shareholder unless the documents provide a compulsory transfer. These are three separate relationships, and people mix them up. Removing someone from the board does not take away a single share, and a founder who still holds 40% of the company keeps the right to vote, to receive information and to petition the NCLT.

Removal as director needs an ordinary resolution of the shareholders under Section 169, after special notice, with the director given a chance to be heard and to circulate a written representation. The board cannot remove a director, whatever the majority of directors want. Our post on resigning or removing a director sets out the steps and filings. If the founder is also an employee, his employment ends under the terms of his employment agreement and labour law, which is a separate exercise; see employment agreement clauses.

Removing a founder from the board of a company that is in substance a partnership, where he was promised management participation, can itself be treated as oppression. The NCLT has the power under Section 242 to set aside the removal or to order a buyout instead. So removal works better as one step in a planned exit, not as a weapon.

What happens when a 50:50 company is deadlocked?

In a 50:50 company with two directors, any disagreement can stop the company. Neither side can pass an ordinary resolution at a general meeting, and if each founder is the only director from his side, the board cannot pass resolutions either. Check the articles first: if they follow Table F, the chairperson of the board has a casting vote on an equality of votes, and the chairperson of a general meeting may also have one. Whoever holds the chair may have more power than either founder realised.

If the shareholders' agreement has a deadlock clause, use it in the order it sets: escalation, mediation, then the buy-sell or valuation mechanism. Follow each step precisely and in writing, because a deadlock notice served out of sequence invites a challenge. If there is no clause, the founders have three options: negotiate, go to the NCLT, or let the company drift into default and strike-off, which is the worst of the three.

The NCLT has two routes. Under Sections 241 and 242, a shareholder who meets the threshold in Section 244 (for a private company, one-tenth of the members or of the issued share capital) can petition for relief against oppression or mismanagement, and the Tribunal can order one group to buy out the other at a fair price, which is often the practical answer to deadlock. Under Section 271(e), the Tribunal can wind up a company where it is just and equitable, and a deadlock in a company that is really a partnership has long been accepted as such a case. Winding up destroys value, so the Tribunal usually prefers a buyout. Our post on oppression and mismanagement petitions before the NCLT explains that procedure.

Who owns the code, the brand and the customers?

Not necessarily the company. Under Section 17 of the Copyright Act, the author of a work is its first owner, and the employer owns it only where the work was made in the course of employment under a contract of service. Founders are often not employees, and much early code and design work is done before the company is even incorporated. Unless there is a written assignment to the company, the founder who wrote the code may own the copyright in it.

An assignment of copyright must be in writing and signed by the assignor (Section 19). The Act also fills gaps against the company: if an assignment does not state its duration, it is treated as five years; if it does not state the territory, it is treated as India only; and if the assignee does not exercise the rights within a year, they can be treated as lapsed unless the deed says otherwise. Investors know this, and a missing or badly drafted IP assignment is one of the first things they ask to be fixed.

When Advocate B.K. Singh looks at a dispute over a codebase, he asks first where the repositories are hosted and in whose account, and only then what the documents say. Possession is not ownership, but a founder who controls the repository, the domain registrar account and the app store developer account can stop the business overnight. Trademarks applied for in a founder's personal name, social media handles and customer databases raise the same question. The exit agreement must transfer every one of them, with the trademark assignment recorded at the Trade Marks Registry; our trademark and copyright page covers the filings.

Money between founders: salary, loans and expenses

Founders often have money tangled up in the company in ways that are not documented. One founder lent the company ₹15 lakh in year one with no loan agreement. Another took no salary for eighteen months and believes he is owed it. A third paid company expenses on his personal card. On exit, each of these turns into a claim, and each is easier to settle than to prove.

Gather the evidence early: bank statements, the company's ledger entries, board resolutions approving any loan or salary, and the founder's own tax returns. A loan recorded in the company's books as a director's loan is a debt of the company; an informal promise of back salary that was never approved by the board usually is not. Unpaid amounts can be netted against the price for the founder's shares, which is often the simplest way to clear them.

Allegations of diversion of funds or customers are a different matter. If you believe a co-founder took money or business, preserve the evidence, have the accounts reviewed, and take advice before making the allegation in writing. An accusation of fraud made loosely in an email to investors can lead to a defamation complaint and will make settlement harder.

Steps to a negotiated co-founder exit

Most co-founder disputes end in a buyout. These are the steps that get there with the least damage.

1. Map the position

   List the shareholding, vested and unvested shares, leaver status as each side sees it, board composition, bank signatories, IP ownership and money owed each way. Agree that list with the other founder if you can; it narrows the dispute.

2. Agree a standstill

   Agree in writing that neither side will change bank mandates, allot shares, remove directors, lock systems or contact investors and customers about the dispute for a short period, say 30 days, while you negotiate. This stops the dispute getting worse while you talk.

3. Fix the price method

   Use the agreement's valuation clause if there is one. If not, agree on a registered valuer, the valuation date, the information the valuer receives and whether any discount applies to a minority stake.

4. Negotiate the package

   Price is only one term. Also agree payment terms, whether the founder keeps any shares, what happens to his loans and unpaid salary, the IP assignment, transition duties, non-solicitation, confidentiality and how the exit is announced.

5. Mediate if talks stall

   A mediator, either at a court-annexed mediation centre or privately, helps when the founders can no longer speak to each other. Commercial disputes of the required value need pre-institution mediation before a suit in any case.

6. Document and file

   Sign a share purchase or transfer agreement, a settlement and release, the founder's resignation as director and the IP assignment. Pay stamp duty, complete the transfer, file DIR-12 within 30 days and update the bank, the registers and the cap table.

Documents to gather before you negotiate or litigate

How are a departing founder's shares valued?

There is no single right number. The usual methods are discounted cash flow, comparable transactions, the price of the last funding round, or net asset value for an asset-heavy business. A registered valuer under Section 247 will apply one or more of these and explain why. For an early startup with little revenue, the last round price is often the most persuasive evidence, adjusted for anything that has changed since.

Two arguments recur. The remaining founders say a minority stake in an unlisted company should be discounted because it carries no control and has no market. The departing founder says he should not be penalised for a minority position the others have forced him into, especially where the company is really a partnership. The NCLT, when it orders a buyout under Section 242, tends to look for a fair value without such discounts where the petitioner has been oppressed.

Settle the valuation date early. Startups change value quickly, and a valuation at the date of departure, at the date of the dispute or at the date of payment can differ by multiples. Each side will prefer the date that suits it, so put the date in the agreement or the standstill letter.

NCLT, arbitration or the police: where does the dispute go?

Claims under the shareholders' agreement, such as enforcement of vesting, leaver terms or a ROFR, go to arbitration if there is an arbitration clause, with urgent interim relief available from the court under Section 9 of the Arbitration and Conciliation Act. Claims about the conduct of the company's affairs, such as exclusion from management, dilution, siphoning or deadlock, go to the NCLT under Sections 241 and 242. The two can run in parallel, and choosing the right first move is a tactical decision.

Criminal complaints are tempting and usually a mistake. Founders sometimes file complaints of cheating or criminal breach of trust under Sections 318 and 316 of the BNS to put pressure on the other side. Where the dispute is in substance about shares, salary or the direction of the business, the police often treat it as civil, and the High Court can quash proceedings under Section 528 of the BNSS where a civil dispute has been given a criminal colour. A criminal case is appropriate only where there is clear evidence of dishonest misappropriation, and even then it rarely resolves the ownership question.

For proceedings before the Tribunal, see our NCLT practice in Delhi; for arbitration, our arbitration and conciliation page.

What not to do during a co-founder dispute

• Do not lock the other founder out. Cutting off a director's access to email, accounts and records is evidence of oppression and can lead to an interim order against you.
• Do not hold a board meeting without proper notice. Resolutions passed at a meeting called on short notice, or without notice to one director, are open to challenge under Section 173.
• Do not allot new shares to dilute the other side. An allotment made to change control in a dispute is a classic ground for the NCLT to set it aside.
• Do not move money or assets. Transferring funds, customers or IP to a new entity during a dispute exposes you to civil claims and, in a clear case, criminal complaints.
• Do not write to investors, staff or customers in anger. Allegations made in writing are hard to withdraw and can found a defamation claim.
• Do not resign before taking advice. A resignation can change your leaver status, your rights as a director and your bargaining position.

Investors, employees and customers during the dispute

Investors usually learn of a co-founder dispute early, because their information rights and reserved matter consents bring it to the surface. Tell them in a short, factual note agreed by both founders if possible: that there is a disagreement, that the business continues, and who is handling what. Investors often have the strongest interest in a quick settlement and may help fund or structure a buyout.

Employees need stability. Agree between the founders who signs salaries and who they report to during the standstill. ESOP holders will want to know their options are safe; under most schemes they are unaffected by a founder's exit, but say so.

Customers and suppliers should hear nothing about the dispute unless it affects them. Make sure contracts are in the company's name, that the company's bank account remains operable with the agreed signatories, and that no founder writes to customers about the other. A dispute that leaks to the market destroys the value both founders are fighting over.

What if there is no company yet, or nothing in writing?

If two people were working together on a business before incorporating a company, sharing costs and expecting to share profits, the law may treat them as partners under Section 4 of the Partnership Act 1932, even without a written deed. A partnership at will can be dissolved by either partner giving notice under Section 43, and each partner is then entitled to an account and a share of the assets. Our post on partnership firm disputes and dissolution covers that route.

If a company was incorporated but nothing else was signed, the Companies Act defaults apply, as explained above, and the founders' informal understanding becomes evidence of what was intended. Messages and emails from the early days, about who would do what and who would own what, become important evidence. Preserve them.

For anyone starting now, the lesson is short: incorporate in the structure that fits the plan, as explained in private limited company or LLP, and sign a shareholders' agreement with vesting, leaver terms and a deadlock clause on day one.

What to do this week

Collect the documents in the list above, take secure copies of company records, and write down in a page what you want the outcome to be: stay and buy the other founder out, leave and be bought out, or keep both founders with new terms. Check whether your agreement has a deadlock or dispute clause with time limits that have already started to run. Then propose a standstill to your co-founder before either of you does something that cannot be undone.

If the other side has already acted, by removing you from the bank mandate, calling a meeting to remove you as director or allotting shares, speed matters. Interim relief from the NCLT or a court is far easier to obtain before the change has taken effect than to reverse afterwards.

If you want an advocate to read your documents and tell you where you stand, the team of Advocate B.K. Singh at B.K. Singh & Associates handles founder disputes, exits and NCLT proceedings as part of our corporate law practice. Send a short summary and the shareholders' agreement through the online enquiry page.