How Do You Cut A Founder Loose? Transitioning a founder is an eventuality that can be done smoothly – and without litigation. –

What do Candice Carpenter, Bill Gates and Pierre Omidyar all have in common? Each founded a successful company – iVillage, Microsoft and eBay, respectively. Each served as CEO at one time. And each knew when to step down and let a professional chief executive take over.

Carpenter relinquished her CEO role nearly four years ago and now is no longer on the board of the women’s online network. Gates, since founding Microsoft, has stepped into the role of Chief Software Architect and let Steve Ballmer worry about the company’s growth. Omidyar – still serving as chairman of the online auctioneer – passed on the CEO baton and spends most of his time in philanthropic activities. There’s no arguing that in each case the succession strategy worked.

But, unfortunately, many entrepreneurs don’t follow suit as easily. Sure, every entrepreneur wants to develop the next great computer company, but many never come close because they don’t have the sense to hand over the reins to a seasoned management pro.

“This is a real issue, and it’s something that most VCs and entrepreneurs ignore,” says George Stamas, an attorney in the Washington, D.C., office of Kirkland & Ellis and a partner with New Enterprise Associates. “The issue gets ignored because no one likes to talk about uncomfortable things, and most of the time everything is going fine at first. It’s later that it becomes a problem.”

However, advanced planning can go a long way.

To be sure, replacing the management is often a reactive move, and thus typically doesn’t happen until a company has made it to the later development stages, missed a growth milestone or failed to meet budget. But by the time that any of these yardsticks are crossed, many entrepreneurs aren’t expecting to be ousted, and the investors may not feel they have the legal justification to do so.

But replacing management is a fairly standard practice.

“Every VC wants its investment to outgrow its first management team. That’s a sign that the company is moving in the right direction,” says Kathy Fields, an attorney with Testa, Hurwitz & Thibeault in Boston.

The founders know that management changes are a potential result of taking an investor’s money. And Fields suggests that it’s best to spell these things out on a sunny day, rather than on the day the founder loses the job.

A Human Issue

In theory, all entrepreneurs want their investments to succeed. But taking that step down to let a professional entrepreneur run the company is for many akin to giving children away to strangers. Even if an entrepreneur knows ahead of time that he eventually will step down, three out of four times they don’t walk away without a fight, one lawyer says.

“It is a hard move for a founder because they have an emotional attachment to the company and they never think another person can run it as well as they did,” says Rob Matlin, a partner with Thelen Reid & Priest in New York. “It is never easy to tell the founder that his future with his company is in jeopardy, and it is too common a problem.”

If an entrepreneur is asked to step into another position or in some cases even leave the company and he is feeling cheated, the next thing a VC could be looking at is a lawsuit. The good news is that there are steps VCs can take to prevent getting bogged down in a time-consuming court battle.

* Get The Dirty Work Out Of The Way

Remember when you were in a kid and your mother told you to play nice and be fair? The same rules apply in the venture world.

VCs should spell out the terms in the beginning of the relationship and be generous. VCs first want to make sure the intellectual property is properly licensed to the company – not to the founder – so it can be used after the founder is gone.

And VCs should make certain the founder is compensated, says Fields.

“The founder has to be properly incentivized so he also wants to do what’s best for the company,” Fields says. “You want the founder to have the ability to keep stock options if he leaves – to retain ties to the company – which will make him bow out easier if necessary.”

Matlin agrees. “No one likes losing money on something they’ve built up,” he says. “If you keep the founder tied to the company and make them a part of the process in some way, they are more likely to transition quietly.”

* Spell It Out

The best way to avoid a lawsuit from a disgruntled founder is to have everything spelled out on paper.

“You need to be very specific on all your agreements and be fair. If a founder is well compensated he will be less likely to cause a problem,” says Jim Cutro, an attorney with Bonnist & Cutro in New Jersey. “You need to have non-compete agreements in place and severance agreements that detail every possible scenario. You want to compensate the players who will play ball and penalize the ones who won’t.”

The details in these contracts can go on and on, but it’s important to lay out a severance payment plan when there is cause for termination, when there isn’t, and what “cause” actually entails, says Matlin. “The more specific a contract is, the better,” he says.

As Stamas, of Kirkland & Ellis puts it, “You don’t want to be playing catch up all the time, wishing you had laid out the terms of the investment months ago.”

Have a succession plan in place and it will save VCs from headaches later on.

* Hiring A New Manager

While moving the founder into a different position can be tough, hiring a successor can be equally as challenging.

To ensure a professional entrepreneur is the right match for an investment, there is no short cut around doing extensive due diligence. Firms such as BancBoston Ventures, Safeguard Scientifics, Mellon Ventures and Golden Gate Capital have gone as far as to hire investigative companies like BackTrack Reports, which provides clients with background checks on potential hires.

“You hire lawyers and accountants to make sure investments look good, why wouldn’t you give the people you are investing in the same amount of scrutiny,” says Chris Manthey, chairman of BackTrack.