Employment Law Considerations for Founders in Emerging Companies

Founders of early-stage companies contribute time and effort well before any formal corporate structure is in place. As a startup matures, it becomes increasingly important to formalize the relationship between the founder and the company, particularly because the founder can occupy multiple legal roles such as shareholder, director, officer and employee. Each role carries distinct rights and obligations, and it’s important to understand their nuances.

Formalizing a Founder’s Relationship

Worker Classification

It is important to consider and define the nature of a founder’s relationship with the company at the outset and on an ongoing basis to ensure the founder is properly classified.

In the early days of a startup, a founder might be an independent contractor who provides limited services to the company as a side hustle. However, as the business gains momentum, this may quickly evolve into an employment relationship.

Whether a founder is an employee or independent contractor depends on several factors, including the degree of control exercised by the company (including in respect of hours of work, location, and method of performing services), the level of integration into the essential functions and management of the business, signing authority, location of work, and whether there is an expectation of exclusivity or the ability to hold other jobs. Misclassification can result in liability to the company, including for unpaid payroll taxes and other withholdings, as well as statutory obligations and potential penalties under applicable employment standards legislation.

Written Agreement

A founder’s relationship with the company should be documented in a written independent contractor or employment agreement, as appropriate. Without a clear agreement in place, startups may face uncertainty around termination entitlements and the founder’s legal status. Among other things, this represents a concern for potential investors. Well-drafted agreements help establish clear expectations, allocate risk and provide a foundation for managing future transitions.

If the founder’s relationship evolves (including a change from independent contractor to employee), the agreement should be updated accordingly.

Crucially, what you call the relationship in an agreement with the company (e.g., contractor agreement or employment agreement) does not determine what the relationship is in fact. A court would still look to the classification-related factors outlined above.

Legal Representation

Founders often draft early-stage agreements informally or in haste during a startup’s initial stages, often without input from legal counsel.

Once legal counsel is engaged, it will need to determine the nature of any existing relationship, assess whether this relationship is appropriate at law and determine whether any agreements need to be entered or amended.

Founders should be aware of the scope of legal representation. When a founder speaks to a lawyer in a representative capacity, the lawyer represents the company — not the founder personally. This is often misunderstood in early-stage settings where founders may fail to recognize that the company is the lawyer’s client.

Unless there is objective evidence that a founder reasonably believed they had a separate solicitor-client relationship (for example, through a retainer or direct confirmation from counsel), the lawyer’s duty is owed solely to the company. This distinction is important when negotiating a founder’s independent contractor and/or employment agreement, especially where there are multiple founders or shareholders. It can also become important later if disagreements arise or a founder departs. The company’s interests, particularly when contemplating a future fundraise or sale, may not align with the founder’s interests. Founders should consider retaining independent legal counsel to protect their interests and avoid potential conflicts. Where there is only one founder and no other shareholders, the distinction between founder and company is relatively blurry, but as the company grows and matures, the potential conflict of interest grows exponentially.

Handling the Exit of a Founder

There may come a point when a founder’s continued involvement no longer aligns with the company’s direction. For example, it’s common for a founder CEO to be replaced with a manager CEO as the startup shifts from finding product market fit to scaling and international expansion. Whether the departure is amicable or contested, addressing key legal considerations in advance can help mitigate risk and ensure a smoother transition.

Dead Equity

When a departed founder continues to hold an equity interest in the startup, this can make it very difficult for the company to raise money and incentivize employees with equity. This is the so-called “dead equity” problem. Any equity a departing founder takes with them is no longer working to grow the company. This is a red flag for VCs because, for one, it leaves less equity available to incentivize current and future employees, including the person who will need to replace the departed founder, and the potential for upside is a major part of startup employees’ compensation packages. It can also make it harder to raise money. There has to be enough equity available to issue to investors over multiple rounds, without diluting existing founders and employees in a way that disincentivizes them from continuing to work to grow the company. To deal with this issue, VCs insist on reverse vesting agreements that permit the company to buy back issued shares in the event a founder resigns. These agreements may provide for different payment terms depending on the circumstances of the departure. For a founder leaving on good terms, the purchase price of the equity may be the then fair value, crediting the founder for their work in advancing the company to the date of departure. If a founder’s role is terminated in circumstances adverse to the company (such as a termination for cause), the applicable purchase price may be a discount from the then fair value or the initial, “nominal” acquisition cost of the equity. While the terms can be negotiated, the imposition of some form of share repurchase arrangement is common practice and protects founders from each other as much as it protects the company and its other investors.

Whether or not their shares have fully vested, founders likely still have voting and board nomination rights. However, if a founder is no longer with the company, they may have different interests than the remaining shareholders on the outcome of certain big events in the company’s life. For example, they may be willing to accept a sale of the company for a lower amount than the remaining investors would. They may also not want the company to raise money if this would dilute their equity. Given the large equity stake founders usually have, it has become market standard to limit a founder’s board nomination rights and voting rights under the various VC-style shareholder agreements to only apply as long as they are actively employed by or a contractor to the company. This protects the company and other shareholders from misalignment.

Termination Entitlements

A founder’s entitlements on termination of employment or engagement will depend on the terms of any governing agreement.

If the founder is engaged as an independent contractor and properly classified as such, the termination of that relationship will be determined by the written agreement.

If the founder is an employee, termination entitlements will be determined with reference to a written employment agreement, along with applicable employment standards legislation and the common law. Most employers in Canada are provincially regulated for employment purposes. Each province has employment standards legislation setting out minimum entitlements upon termination of employment without cause. These include mandatory notice periods that must be satisfied through working notice, pay in lieu of notice or a combination of both. During the statutory notice period, all integral components of compensation (and, in some provinces, benefits) must be maintained. Statutory notice is typically calculated at approximately one week per year of service, subject to provincial caps. In Ontario, if the company has an annual global payroll of C$2.5-million or more, employees with five or more years of service are also entitled to statutory severance pay calculated as an additional one week of pay per completed year of service (and pro-rated amount of one week per completed month of service) to a maximum of 26 weeks. Employers cannot contract out of these statutory minimum entitlements, nor can they be made conditional on a full and final release. However, employers can contractually limit entitlements on termination to such statutory minimums.

If there is no written agreement limiting an employee to their minimum statutory entitlements (or another contractual entitlement), or if the agreement is unenforceable, the employee will be entitled to reasonable notice. Reasonable notice is often significantly greater than, but includes, the minimum statutory entitlements. Courts assess reasonable notice based on several factors, such as the individual’s age, length of service, position and level of compensation, and typically award three to six weeks of notice per year of service to a general upper limit of 24 months.

It is important to note that in Quebec, employers cannot contractually limit notice entitlements to statutory minimums, and all employees are entitled to reasonable notice upon termination without cause as described above.

In the interest of a smooth transition and to manage potential liability, it is advisable to have clear, written employment agreements that address termination entitlements. While it is possible to contractually limit termination entitlements to statutory minimums, this would not be typical for a founder. More commonly, parties agree to a defined contractual entitlement, whether as a fixed amount or based on a formula. Any contractual payments or benefits that exceed the minimum statutory entitlements should be conditional on a full and final release.

Protective Measures

In addition to contractual termination entitlements, employment agreements should include provisions that mitigate risk to the business following a founder’s departure. These commonly include restrictive covenants such as non-solicitation and non-competition clauses (where legally permissible), obligations to return company property, maintain confidentiality, and non-disparagement clauses to protect the company’s reputation.

Key Takeaway

It is important to engage with legal counsel early in the startup process to ensure founders are properly classified and bound by written agreements that appropriately protect the company and set it up for future success.

For more information, please contact Laura Blumenfeld, Marko Trivun, Christopher Jones, or any other member of our Emerging Companies & Venture Capital or Employment & Labour groups.