Founders’ Dispute in a Tech Company

This month, we advised on a complex buyout transaction between two founders of a successful tech company. As part of the transaction, one founder acquired the other’s stake, alongside mediation between the parties and the handling of the commercial, corporate and tax aspects of the separation.

This account is shared with the shareholders’ consent. Certain details have been changed or omitted in order to preserve the confidentiality of the parties and the company.

The two founders established an innovative company together, which went on to become a leader in its field. The company prospered. Their partnership, however, steadily deteriorated.

The most acute dispute concerned the company’s future direction: one founder wanted to relocate to Europe and open an additional research and development centre for the company; the other strongly objected, fearing leakage of know-how.

The impact of the dispute on the company

What began as a disagreement between the two founders gradually developed into a crisis that affected the entire company – from management and the board to employees and investors.

The disagreements touched almost every decision: which developments to prioritise, whether to pursue acquisitions, whom to recruit, how much to invest in growth, and how to allocate resources.

After a prolonged period of arguments and unilateral steps, factions formed within the company. One founder moved to another floor in the offices, the atmosphere deteriorated, and the tension spread to management and employees. At that stage, the dispute had already begun to impair decision-making and disrupt day-to-day operations.

Even in board meetings, the situation could no longer be concealed. Discussions were tense, every decision brought the conflict back to the surface, and investors began to worry about the company’s stability.

Those concerns became tangible when the possibility of a further fundraising round arose. Some investors were unwilling to participate so long as it remained unclear who was leading the company and in what direction. In their view, injecting additional capital in those circumstances would have been a gamble.

At the same time, real commercial risks also emerged. One of the central concerns was the potential loss of the company’s unique know-how, including if one of the founders were to leave for a competitor. In parallel, concerns grew that key employees would leave as a result of the uncertainty and the ongoing tension.

At a certain point, it became clear that the situation could not continue. Either the company would be sold, or one founder would acquire the other’s stake.

Who buys out whom, and how is it done?

One option was a direct sale of shares between the two founders – a relatively simple route from a corporate perspective, but one that requires the buyer to raise the full financing for the transaction independently.

Another option was for the company itself to repurchase the departing founder’s shares. This alternative may ease the financing challenge, but it raises different corporate and tax questions – and requires an examination of the company’s available resources, distribution constraints and the implications for each side.

Each alternative had advantages and disadvantages. A solution that eases the financing burden for the buyer may increase the seller’s tax exposure. A structure that reduces tax in the short term may place pressure on the company’s cash flow, and a mechanism that protects one party may increase uncertainty for the other.

The challenge was not to find a separate solution for each issue, but to build a single structure in which all the moving parts worked together.

How do you decide?

Company owners often assume that once a principled decision to separate has been made, most of the work is already behind them. In practice, the opposite is true.

From the moment the parties agree that one of them will exit, a stage begins in which each decision affects several others. Price affects financing, financing affects the transaction structure, the transaction structure affects tax, and tax ultimately affects how much each side will actually receive.

The complexity increases further where the company is a private company with investors, preferential rights and different share classes, SAFE agreements, employee option plans, international operations, or a high degree of dependence on know-how and relationships controlled by the departing founder.

In that situation, a buyout is not merely a share transfer. It is a transaction involving the transfer of control, allocation of risk, preservation of commercial stability and precise tax planning.

As part of the overall analysis, it was also necessary to determine what would happen on the day after the separation. Would the selling founder support the company during a transition period? What consulting services would be required? How would the knowledge accumulated by that founder be transferred? Would a non-compete undertaking be included and, if so, to what extent, in which fields and for how long?

Each of these questions carried commercial and tax implications that could not be left open.

Yet just when the separation structure seemed to be taking shape, we raised questions that few people think to ask at this stage – tax questions, the answers to which affect the transaction structure long before price is even discussed.

Does the company benefit from tax incentives and, if so, how do they affect the choice of separation route? Are any of the shareholders non-residents or citizens of another country – a fact that may entirely alter the tax picture?

In our case, the answers only made the picture more complicated.

The company benefited from incentives under the Law for the Encouragement of Capital Investments – a fact that directly affected the choice of transaction structure. The tax rate applicable to a dividend distributed from preferred profits is lower than the tax rate applicable to a capital gain realised by a substantial shareholder on the sale of shares, disregarding profits eligible for distribution, which was an additional issue addressed separately.

Accordingly, the question whether to proceed by way of a direct sale, a share buyback, a dividend distribution or a combination of these was not merely a question of financing. It was also a question of material tax differentials.

To this was added the fact that one of the founders was a US citizen. In the United States, unlike in most countries, tax is determined by reference to citizenship as well as residence. The implication was that the transaction could not be analysed solely through the prism of Israeli tax law. Each element of the transaction therefore had to be reviewed under the US tax system as well.

Once the parties had agreed on the principle of separation and on who would acquire whom, the central question remained: what was the company worth?

Below are the options that were considered and the considerations attached to each of them.

What is the company worth?

Valuation based on the last funding round

The question arose whether to rely on the valuation set in the last funding round, which had taken place about a year earlier. It had been a genuine transaction with external investors, so it was by no means a poor reference point.

The parties, however, saw a completely different picture.

The buyer argued that the company’s value had fallen since that round. In his view, the pace of change in the artificial intelligence sector had eroded barriers to entry and increased the risk that some of the company’s technology or product would lose its uniqueness.

The seller presented the opposite picture. From his perspective, the new developments he had promoted were intended to integrate AI capabilities into the company’s products, strengthen its competitive advantage and open up new revenue streams. In his view, AI had not reduced value. On the contrary.

External valuation

Even the option of commissioning an external valuation did not resolve the dispute. The parties needed to agree on the identity of the valuer, the scope of the valuer’s authority and the methodology to be used.

We began examining a number of different valuation methods. One possibility was a DCF valuation – discounted future cash flows – although that method is less common in valuing tech companies.

This method too depends on a series of assumptions: revenue forecasts, growth rates, profitability margins, required investment, terminal value at the end of the forecast period, and the discount rate, including WACC.

Any change in a single parameter may trigger a new dispute. In this case, the question of how AI would affect revenues, costs, competition and the need for development investment formed a direct part of the valuation exercise.

BMBY

A simple solution on paper, but not always suitable in practice – one of the options considered was an auction mechanism using a BMBY, or Buy Me Buy You, structure.

Under this mechanism, one shareholder offers a price for the shares and the other chooses either to sell his stake at that price or to purchase the offeror’s stake at the same price.

On paper, BMBY is supposed to drive fair pricing. In practice, however, the mechanism is not always symmetrical: where one side has an advantage in financing, information or managerial capacity, the price may be mathematically fair but not economically fair.

Accordingly, the timetable, financing sources and practical ability of each side to complete the transaction were also examined.

Certainty versus tax deferral

An earn-out mechanism allows the consideration to be split into two parts: one part is paid immediately, and a further part is paid later based on the company’s actual performance.

This can bridge the gap between a seller who believes in growth and a buyer who is unwilling to pay upfront for projections that have not yet materialised.

However, the mechanism is complex to implement. It is necessary to define in advance which metrics will entitle the seller to additional payment, how they will be calculated, and how to prevent the buyer from influencing the outcome once control has passed.

Alongside this, a tax question arises: the more certain the future consideration is, the greater the risk that the tax authorities will treat it as capital gain already realised on the transaction date. Genuine uncertainty, by contrast, may permit tax deferral – but leaves the seller exposed to the possibility that the additional consideration may never be paid.

Additional considerations in determining value

As part of the analysis, SAFE agreements signed with investors also came into focus, as they give those investors the right to receive shares in the future. It was necessary to examine how those agreements affected the number of shares, the value of the holdings and the expected dilution.

In addition, the company had granted options to employees and office holders. Here too, it was necessary to distinguish between options that had already vested, options that had not yet vested, the remaining pool available for grant, and terms that might be affected by the change of control.

Some of the options were also subject to a double trigger mechanism. This meant that accelerated vesting would not occur merely as a result of the transaction itself, but would also require a further event, such as the employee’s dismissal or a material deterioration in the employee’s terms of employment following the change of control.

It was necessary to determine how the transaction affected those acceleration mechanisms, what would happen to employees identified with the selling founder, what the equity value was on a fully diluted basis, and what pre-emption or preferential rights the investors held.

After a lengthy process, we succeeded in bridging the gap between the parties and reaching agreement. It was determined who would acquire the shares, at what valuation, through which structure, and how control would be transferred.

It appeared that the path to completion was clear.

Then the issue arose that almost caused the entire transaction to collapse.

Tax exposure relating to an overseas subsidiary

The company had significant tax exposure arising from an issue connected with one of its overseas subsidiaries. The extent of that exposure was disputed: in the optimistic scenario it amounted to only a few million shekels, while in the more stringent scenario the exposure was materially higher.

The buyer regarded this as a material risk that could alter the commercial viability of the transaction altogether, and demanded that the full amount of the potential exposure be placed in escrow until the end of the limitation period.

The seller believed that the likelihood of the exposure materialising was low and that there was therefore no justification for reducing the full amount from the consideration or leaving funds in escrow for a number of years.

We examined the circumstances, the subsidiary’s activities and the relevant legal provisions. Our conclusion was that even if the potential exposure was high, the likelihood of its full crystallisation was low and, if challenged by the tax authority, the company would have strong professional arguments that, in our view, would lead to a settlement at a significantly lower amount.

Yet a professional assessment, however well founded, is not always enough to persuade a buyer to bear a risk that, if it materialises, could have catastrophic consequences.

After every other issue had been resolved, it appeared that the transaction was about to fall apart because of an exposure that no one knew would ever materialise at all.

The solution we proposed was tax insurance – a well-known tool in international transactions, but still not especially common in Israeli deals.

Under such a policy, the insurer reviews a defined tax exposure, the factual basis, the law and the professional arguments, and decides whether it is prepared to assume the risk, subject to the terms of the policy.

Unlike general representations and warranties insurance – which covers unknown risks discovered after the transaction – tax insurance focuses on a specific issue that has already been identified and analysed in advance.

Together with an international insurer with whom we are familiar from previous transactions, we conducted an expedited underwriting process based on the professional opinion we had prepared. We presented the transaction structure, the subsidiary’s activities, the exposure and the arguments available to the company in the event of a challenge by the tax authority.

At the end of the process, a policy was obtained at a cost representing only a negligible fraction of the potential exposure.

The result: the buyer received defined protection against the exposure, the seller received most of the consideration at completion without the need for a prolonged escrow arrangement, and the transaction moved forward.

Conclusion

To reach a solution, it was necessary to hold all the pieces of the puzzle at once: the holding structure, the personal dispute, investor concerns, the benefits under the Law for the Encouragement of Capital Investments, US taxation, the SAFE agreements, the options, the double trigger mechanism, the valuation methodologies, the financing options, the earn-out mechanism and the tax exposure arising from the overseas subsidiary.

At every stage, we were required to distinguish between emotion and interest, between theoretical value and a price that could actually be financed, and between maximum exposure on paper and the real practical risk.

Complex transactions are not resolved with a single tool. They are resolved by looking at the full picture, understanding how each decision affects all the others, and being prepared to look for solutions outside the usual toolbox.

In this case, the combination of mediation, transaction planning, valuation, Israeli and international taxation, and tax insurance turned a dispute that threatened to damage the company into a transaction that the parties were able to complete.

Nimrod Yaron & Co. has experience in advising on complex transactions, founders’ disputes, Israeli and international tax planning, and the development of creative legal solutions.

If you are dealing with a buyout transaction, tax exposure or a dispute between partners, we would be pleased to assist.