What Is and Isn’t Permissible When Startup Founders Split

The Tel Aviv District Court (Economic Department) recently ruled that a partner in a startup breached his obligations as an officer in the company, as well as other obligations toward his former partner in that company. The ruling derived from the fact that the defendant founded a new company in a field similar to the first company, making use of the reputation and experience of the initial company.

Previous Joint Venture

The ruling comes in a lawsuit filed by a partner in Harvest against his former partner and against the new company the former partner founded, Empirical. It also included claims against the defendant’s partners in Empirical. The backdrop to the lawsuit was a previous joint venture founded by the plaintiff and the defendant, which was successful (particularly, a successful pilot of a product the JV developed at a large international company). Subsequently, the plaintiff and the defendant jointly founded Harvest Ltd., which they held in equal shares. Harvest owned the JV and all associated intellectual property rights. The company operated without the two founders signing a founders’ agreement.

Founders Split

Shortly thereafter, disputes led to the founders’ separation. The parties did not sign a separation agreement. The defendant announced that, as far as he was concerned, “we should each go our own separate way,” and expressed his willingness not to engage in fields relating to Harvest’s field of business.

Concurrently, the defendant launched another venture, without the plaintiff, in the same field of business as Harvest, establishing Empirical Ltd. with two other partners. Upon learning this, the plaintiff sued his former partner, Empirical, and its shareholders. The main allegations were that, as an officer of Harvest, the former partner breached his obligations to refrain from competing with Harvest’s business and from exploiting its business opportunity. The plaintiff also alleged the partner had breached other obligations as a shareholder of Harvest. Therefore, the plaintiff petitioned for relief that would award him 50% of Empirical’s shares.

Absence of Founders’ Agreement Does Not Exempt Founders from Statutory Obligations

The court found that, although there was no explicit agreement (from the outset) between the plaintiff and the defendant defining Harvest’s field of business, there was also no agreement about the fieldfields of business in which they could operate independently. The court rejected the defense’s argument that the fact that no founders’ agreement was signed shows that no restriction on competing with Harvest’s business was imposed on the defendant. The court stated that it is advisable for founders of a company to draw up a founders’ agreement between them. However, the absence of such an agreement does not release the company’s officers from their obligations pursuant to the Companies Law.

The court also found that Empirical made massive use of Harvest’s resources, in that it used Harvest’s experience and reputation to develop Empirical’s business vis-a-vis potential investors and customers. For example, the defendant and Empirical made use of the results of the successful pilot executed by the plaintiff and defendant’s joint venture, presenting them as a tool to recruit potential investors and customers for Empirical.

Ultimately, the court found that Empirical’s actions clearly competed with Harvest’s field of business. The defendant claimed Empirical had “changed direction” six months after its founding and focused on another field of business different from that of Harvest. The court ruled that even if Empirical could substantiate this claim, it would not help the defendant. This is because the field of business in which Empirical ultimately engaged is materially close to, and significantly interfaces with, the field of business Harvest engaged in from the outset.

Separation Agreement

The court also ruled that since the negotiations conducted by the parties upon their separation did not materialize into a binding separation agreement, if the defendant wished to operate in Harvest’s field of business, he was obligated to undertake a private bidding procedure with the plaintiff, or act to liquidate the original company. Having failed to do so, the defendant remains an officer and a shareholder of Harvest. As such, he remains subject to all of the relevant obligations pursuant to the Companies Law.

Consequently, the court ruled the defendant breached his obligations to Harvest and to the plaintiff.

Avoidable Dispute

On the other hand, the court ordered not to award the relief sought by the plaintiff (50% of Empirical’s shares). This is because awarding the petitioned relief would revert the plaintiff and defendant to being partners, this time in Empirical, running contrary to their desire to separate in the first place. In lieu of this, the court awarded the plaintiff declaratory relief, whereby it ruled the defendant breached his obligations to Harvest and to the plaintiff, and allowed the plaintiff to file a separate monetary claim pursuant to that declaratory relief.

This ruling represents a quintessential example of a dispute that could have been avoided had the parties sought legal counsel before embarking on a joint venture (or, alternatively, prior to splitting up their partnership in the joint venture).

Entrepreneurs or investors in startups should make sure to protect themselves by signing a duly prepared founders’ agreement. Such an agreement will regulate the rights and obligations of the company’s shareholders, its fields of business, the restrictions imposed on shareholders not to compete with the company, agreed separation arrangements, and a host of other matters that require regulation in advance.

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Barnea Jaffa Lande’s Corporate and Litigation Departments are at your service to answer any questions about founders’ agreements, shareholder disputes, and other questions.

Adv. Avinadav Preuss is an associate in the firm’s Litigation Department.