Reasonable or optimistic: Clarifying expectations when entering into vesting agreements
By Nikita Munjal and Matthew Literovich
Vesting agreements are day-one agreements for most startups. With the way Canadian corporate, employment and tax laws are structured, they are the simplest and most effective way to allocate economic incentives among a founding team when the future of a startup is very murky and its resources are limited. As practitioners in the space, we had some pause when we read the recent decision by the Ontario Court of Appeal in Pereira v. TYLT Technologies Inc. (TYLTGO), a case that addressed what constitutes “reasonable” expectations of founders operating as directors, shareholders and employees of a startup. While the outcome of this case is yet to be settled as it has been remitted back to the Superior Court of Justice to be decided at trial, it raises questions about the intersection of standard commercial practice with our inherent concepts of justice and fairness when founders enter into vesting agreements.
Background
The appellant, Jaden Pereira (Pereira), was the founder and CEO of the respondent corporation, Tylt Innovations Inc., which later became TYLT Technologies Inc. (TYLTGO). After Pereira brought the respondent Aaron Paul (Paul) into the business, TYLTGO was reincorporated federally under the Canadian Business Corporations Act (the CBCA). Pereira and Paul entered into employment and stock restriction agreements and sought new investments. One of the conditions Pereira and Paul accepted as part of a round of equity financing was electing Khaled Hussein (Hussein), a representative of a major investor, to TYLTGO’s board. Following the transaction, Paul, Hussein and Pereira each occupied one seat on the board, creating a board of three where any two votes could carry the day.
Shortly thereafter, allegations of mismanagement and interpersonal conflict arose between the three board members, which resulted in:
1. Termination of Pereira’s employment as a result of a majority vote of the board of directors – the majority being Paul and Hussein;
2. The respondent corporation exercising its rights under the stock restriction agreement and repurchasing Pereira’s unvested shares for a nominal fee; and
3. Pereira’s removal as director and CEO of the respondent corporation.
These results were created, to our understanding, pursuant to the terms of a vesting agreement that Pereira had entered. The vesting agreement provided that if Pereira was terminated, his shares could be repurchased and, consequently, upon the repurchase of his shares, he would not have the votes necessary to maintain his director position. In response, Pereira sought an oppression remedy under section 241 of the CBCA, arguing that the conduct exercised by Paul and the respondent corporation amounted to oppression.
The oppression remedy is an equitable remedy that allows a complainant to apply to the court for the rectification of unfair corporate conduct. An equitable remedy, if drastic oversimplification will be permitted for the sake of understanding, is the ability of the court to say “notwithstanding that everything that happened followed the letter of all of the laws and contracts that apply here, something about this result seems deeply unfair,” and gives the court latitude to remedy oppressive conduct with the wide array of tools at its disposal to reach a “fair” outcome. For this reason, oppression claims are fact-specific and involve a two-part inquiry. First, the party seeking a remedy must establish that the conduct complained of breached their reasonable expectations. Second, if a breach of reasonable expectations is established, the complainant must provide sufficient evidence to satisfy the court that the conduct at issue amounts to “oppression,” “unfair prejudice” or “unfair disregard.”
The application judge found that the evidence was insufficient to conclude that Pereira’s expectation of continuing his position with TYLTGO indefinitely was reasonable, which was an assessment of his rights as an employee. Pereira appealed on the basis that the application judge did not consider his expectations as a shareholder and director. In other words, as a shareholder and director, Pereira had expectations that he would continue with the respondent corporation even after being terminated as an employee.
The Court of Appeal found that the application judge took an “overly narrow approach” by focusing on the language of the stock restriction agreement signed by the parties. The application judge’s misapplication of the factors set out by the Supreme Court of Canada in BCE Inc. v. 1976 Debentureholders resulted in overlooking: (i) the events that led to Pereira’s termination and subsequent repurchase of his shares, (ii) a mischaracterization of Pereira’s expectation for continuing with TYLTGO as “indefinitely,” as opposed to three years, when his shares would have fully vested and (iii) the nature of Pereira’s role as the founder of a small corporation. The application judge is to review the matter again and this time take a wider view of the assessment.
Our view
Getting a matter referred back by an appeal court doesn’t actually prevent the same outcome from occurring with a modified explanation. For this reason, part of the debate in our office has been on whether this case is a problem for the existing vesting agreement regime that has been used by most of the regular practitioners in the startup space. The simple answer may be “no” because we don’t have a final decision, but there is a live issue about understanding the role that vesting agreements play in startups.
We talked about the case more so than what a vesting agreement is at this point, so let’s start there. The idea behind a vesting agreement is that if you and three friends form a startup, you may each start with 25% of the startup (one quarter each), but that percentage, while a great starting place, may not actually reflect the work that each of you will put in over time to make the startup a success. The founder who loses interest after six months is pretty unlikely to have contributed to the success of the corporation the same amount as the founder who goes on to be the CEO for the next ten years, and rewarding them equally is probably not in line with anyone’s reasonable expectations. The problem is that at the point where you’re issuing all your first shares, you don’t know who is going to bail after six months and who is in it for the long haul.
Enter the vesting agreement.
The vesting agreement is an agreement that founders enter into as a condition of receiving their shares that says that if they leave the company early, they will forfeit some of those shares. Typically it’s structured so that if you leave before the end of the first year, none of your shares are protected from the buyback by the company at nominal value, and then you get protection on a 25% chunk at the start of each year until after four full years, at which point none of the shares can be bought back. This is referred to as a one-year cliff with four years’ vesting overall. The vesting agreement is a blunt tool, no doubt. A founder who slacks off for three years may actually have contributed less than the founder who worked hard for nine months and had to resign due to a family emergency. At the point the agreements are entered into, however, it’s very difficult to use much more than a time basis for the vesting terms.
In Pereira v. TYLT Technologies Inc. (TYLTGO), the vesting provisions in the stock restriction agreement held that Pereira and Paul’s common shares, representing 57.5% and 42.5% of the total issued common shares, respectively, were to vest by an initial 25% on July 31, 2020. The balance of the shares would vest in 25% increments over the following three years, fully vesting by July 31, 2023. In other words, if Pereira’s termination had occurred after July 31, 2023, the value he would have received upon the subsequent buyback of his shares would have been significantly higher.
The catch in this case is that the vesting agreement didn’t, to our knowledge, distinguish between resignation and termination, or even termination with cause versus without cause. If Pereira had simply resigned and walked away, or had been terminated for cause due to embezzlement (which is not alleged here and is merely an example), it would be difficult to claim that anything other than the terms of the vesting agreement should apply. The fact, however, that he was seemingly unceremoniously dumped by his own company does seem to grate, at first blush, against our sense of inherent fairness.
However, buybacks on simple termination are actually very common in this space. The reason for such an approach is that the bar set to establish “cause” for termination under employment law means that a founder can be a total drag on the future of the company without ever actually triggering a “for cause” termination, leaving a company hamstrung by a poor founder with no way out. When such a termination is triggered by the board, it still has to act in the best interest of the company, pursuant to established common law duties of directors, but the challenge there would be on the decision-making of the board, not on whether the company’s conduct was oppressive, though they may go hand in hand.
Conclusion
All of this is to say that Pereira’s outcome in this case may be the result of everything working as intended and this outcome may be an inherent risk when one founder has interpersonal difficulties with co-founders. Law is imperfect in many number of areas of business, but it’s particularly acute in the startup space. Founders don’t have the resources to craft vesting agreements that meticulously capture exactly what constitutes a contribution to a company that is currently just an idea, and it would be unreasonable to expect such standards. The space is dependent on trust, goodwill, and some reasonably, but not perfectly drafted documents to serve as guidelines for that.
For the moment, the outcome of this case is unsettled as it has been remitted back to the Superior Court of Justice for a trial. Given that an analysis of the feasibility of an oppression remedy claim is a fact-specific inquiry that requires consideration of various factors, including the relationship between the parties, and the judge will have access to far more detail about the relationships of these parties than we do from the sidelines, the more prudent conclusion is probably just that we should wait to see the overall outcome. That said, there is a lesson here regardless of the outcome – founders should ensure they understand the consequences of entering into agreements, particularly ones to entice investors, even if they do not believe these agreements are likely to result in said consequences.
P.S.
Interestingly, in this case, no one seemed to raise the argument of whether the other two directors, who had an indirect financial interest in the removal of Pereira from the board (which permitted the buyback of his shares and therefore, their increased economic position in the company), constituted a conflict of interest under corporate law. We were surprised there wasn’t a more fertile ground to address the matter that way.
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