Founders are juggling multiple roles and responsibilities. Amidst the whirlwind of raising funds, recruiting talent and launching innovative products, it’s easy to let corporate governance slip through the cracks. However, founders should be cautious not to overlook their fiduciary duties. These duties are core legal and ethical obligations in the pursuit of success.
A typical startup founder serves as a member of the board of directors and as an officer of the company. In both roles, they are bound by fiduciary duties. This article discusses the fiduciary duties of founders in a startup, including the duty of care and the duty of loyalty. It explains what these duties entail, how they apply in practical situations, and the importance of seeking legal advice when making decisions that may impact the company and its shareholders. The article also includes examples illustrating how founders can fulfill their fiduciary duties and maintain the trust of investors and other stakeholders.
Note that corporate law in the U.S. is state-specific, so you’ll want to work with counsel to understand the nuances of your state. If you’re looking for counsel, feel free to reach out to us here.
Duty of Care
The duty of care, in the context of a startup founder, refers to the obligation to make decisions with a reasonable degree of attention, diligence and skill that a prudent person in a similar position would use under similar circumstances. This involves taking the time to adequately inform oneself about a decision, carefully deliberating the potential outcomes and then making a rational decision in the best interest of the startup.
In practical terms, it means founders must take reasonable steps to understand their business, the market, and the risks and opportunities that exist. It also includes ensuring they are up to date with crucial details such as the startup’s financial health, legal obligations, employee welfare and strategic position. If they’re making a decision that requires expert advice, such as a major investment, they are expected to seek appropriate counsel to help inform their decision.
For example, if a founder decides to pivot the company into a new market, they should undertake thorough market research, evaluate the financial implications, assess the competitive landscape and solicit expert opinions if needed before making a final decision. Ignoring these steps and making a hasty decision could be seen as a breach of the duty of care.
However, it’s worth noting that the duty of care does not mean every decision a founder makes must be successful. The “business judgment rule” often protects founders and directors from being held liable for decisions that turn out poorly, as long as they acted in good faith, did not have conflicts of interest and made a rational decision based on the information available at the time.
Example: Making Decisions On a Major Acquisition
Let’s imagine you’re the founder of a thriving tech startup that’s developed a revolutionary data analysis tool. Your startup has gained significant traction and attracted the interest of a larger technology firm. This larger firm offers to acquire your startup for a substantial sum.
As a part of your fiduciary duty of care, it is essential that you and the other directors carry out a thorough due diligence process before accepting or declining this acquisition offer. This process would include:
- Detailed Evaluation of the Proposal. You should thoroughly understand the terms of the acquisition offer. This includes the financial aspects, such as the total purchase price and how it will be paid (e.g., in cash, stocks, etc.), as well as non-financial aspects like potential roles for existing employees post-acquisition and plans for the product your startup has developed.
- Assessing Alternatives. Are there other options available? Could there be other potential buyers who might offer a better deal? Or could the company potentially raise additional funding to continue independent operation and growth, which might lead to a higher valuation in the future? Considering all possible alternatives is crucial to making an informed decision.
- Seeking Expert Advice. In complex matters like a major acquisition, it’s usually prudent to seek the advice of experienced legal and financial advisors. They can provide valuable insights and guidance, help you avoid potential pitfalls, and ensure that the interests of all shareholders are being adequately protected.
- Evaluating Long-Term Impact. You should consider the long-term consequences of the acquisition on all stakeholders involved — not just the immediate financial gain. This includes considering the impact on employees, customers and investors.
The duty of care mandates that all these steps are carried out diligently and prudently. It’s not about making the “right” decision in hindsight but rather about making the best possible decision given the information available at the time. If the directors simply accept the first offer that comes along without conducting due diligence, they could be seen as neglecting their duty of care. Even if the offer turns out to be beneficial in hindsight, the process through which the decision was made could still be subject to criticism if it didn’t involve sufficient care.
Duty of Loyalty
The duty of loyalty in a startup context requires founders and directors to always act in the best interest of the company. It implies that their decisions and actions should prioritize the company’s interests over their personal benefits or any other external interests. In a practical sense, the duty of loyalty can involve several aspects:
- Avoiding Conflicts of Interest. Founders and directors must avoid situations where their personal interests are in conflict with those of the company. For example, if a founder has an opportunity to invest in a competing startup or to take on a consulting role that would divert their time and attention away from their own company, this could represent a conflict of interest.
- No Self-Dealing. Founders and directors are prohibited from using their position in the company to secure personal benefits. For instance, they should not engage in transactions with the company that are designed primarily for their own financial gain, such as selling assets they personally own to the company at inflated prices.
- Founders and directors have access to sensitive company information. The duty of loyalty requires them to protect this information and not use it for personal gain, such as trading company stocks based on non-public information or sharing trade secrets with external parties.
- Acting in Good Faith. Founders and directors are required to act honestly and transparently, disclosing any potential conflicts of interest and not engaging in deceptive or fraudulent actions.
In essence, the duty of loyalty requires founders to commit themselves fully to the success of the startup and to make decisions that serve its best interests.
Imagine a scenario where the co-founders of a startup have developed a unique software platform. Let’s call these founders John and Jane. The platform has gained considerable market traction, and the company is doing well.
Example: Sale of Proprietary Technology
A large tech corporation approaches John with an offer to buy the proprietary technology for a substantial amount, intending to incorporate it into their own suite of products. This offer includes a lucrative job for John within the corporation.
John might be personally tempted by the significant financial gain and prestige associated with working at the tech corporation. However, accepting this offer would deprive the startup of its key asset and likely lead to its failure, causing significant harm to Jane, the employees and the shareholders.
The duty of loyalty here requires John to put the startup’s interests before his personal gain. If he believes that the tech corporation’s offer is not in the best interest of the company, he must reject it despite the personal benefits. If John were to accept the offer without the approval of the startup’s board of directors or without exploring how the offer could be structured to benefit the startup, he could potentially be breaching his duty of loyalty.
This is a simplified example, and real-life situations can be far more complex, requiring careful legal and business judgment. However, it illustrates the core principle of duty of loyalty; a founder’s decisions and actions should always prioritize the best interest of the company.
How to Cleanse an Interested Party Transaction
An “interested party transaction” is a business deal or arrangement between two parties where one party has the potential to gain substantial personal benefit from the deal. This might occur, for example, when a founder of a company also serves as a director and decides to enter into a transaction between the company and a separate business that the founder owns.
Interested party transactions can potentially lead to a breach of the duty of loyalty because they can create situations where the personal interests of a founder, director or officer could conflict with the best interests of the company. This situation is often referred to as a conflict of interest.
However, not all interested party transactions are improper or necessarily breach the duty of loyalty. There are procedures, often called “cleansing” methods, which can help validate such transactions:
- Full Disclosure. The interested party should fully disclose the nature of their interest in the transaction to the rest of the board and the shareholders.
- Disinterested Approval. After disclosure, the transaction should be reviewed and approved by the disinterested directors or shareholders — those who do not have a personal interest in the transaction. This can be done by a vote in which the interested party does not participate.
- Fairness. The transaction should be demonstrably fair to the company. This often involves obtaining an independent appraisal or ensuring that the company is receiving reasonably equivalent value in return.
These measures are designed to ensure that the transaction is carried out in a manner that protects the company and its shareholders, and that any conflicts of interest are properly managed. If followed appropriately, these steps can prevent a breach of the duty of loyalty and can help maintain trust between the company’s leadership and its shareholders. It’s always advisable for startup founders to seek legal counsel when dealing with potential conflicts of interest or interested party transactions.
Importance of Seeking Legal Advice
Founders should seek legal advice when making decisions that may impact shareholders or the company as a whole. This includes decisions related to mergers and acquisitions, fundraising, contracts, and regulatory compliance.
Legal counsel can provide valuable insight into the potential risks and benefits of various courses of action, as well as guidance on how to navigate complex legal issues. Additionally, lawyers can ensure that all necessary legal requirements are met and that the company is protected from potential liability.
By seeking legal advice, founders can make more informed decisions and avoid costly mistakes that could harm the company or its shareholders. Furthermore, having a trusted legal advisor can help build confidence with investors and other stakeholders in the company’s ability to manage risk effectively.
It is important for founders to establish a relationship with a qualified attorney early on in the startup process. This allows them to build a strong foundation for legal compliance and risk management from the outset. As the company grows and faces new challenges, having an established legal advisor can be invaluable in navigating complex legal issues and ensuring long-term success. If you’re looking for legal counsel, feel free to reach out to us here.
In conclusion, founders of startups have a fiduciary duty to act in the best interest of the company and its shareholders. This includes the duty of care, which requires founders to make decisions with a reasonable degree of attention, diligence and skill, and the duty of loyalty, which requires founders to prioritize the interests of the company over their personal benefits or external interests. While these duties can be complex and nuanced, seeking legal advice can help founders navigate these issues and make informed decisions. Ultimately, fulfilling these duties is essential to building a successful and sustainable startup.