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Importance of Founders’ Agreement in a Start-up

Author – Advocate Madhavan Srivatsan, Advocate Tuhin Batra and Associate Rishima Rawat

When looking for a team for start-up, young entrepreneurs generally turn towards trusted friends, colleagues or family members. There is an inherent trust in the relationship that the other person will bring in his expertise and work towards the growth of the new venture. Such arrangements are usually agreed verbally among the founders without any formal documentation. Irrespective of the type of business entity proposed to be incorporated (limited partnership or a company), proceeding without a formal founders’ agreement is the single biggest mistake entrepreneurs can commit before commencing their business operations. Imagine a number of situations that can arise. What will be the role and responsibilities of the respective founder? How will the equity of the company be divided? Who will own the intellectual property rights (IPR) of the company? If there are more than one founder (which is often the case), then what kinds of rights and obligations to be shared between the founders? What happens in next round of financing? What if there is a disagreement on a major business decision? Whose decision will prevail? How will this disagreement reflect before the investors when requesting them for funds? What happens if one of the founders leave? Such issues are bound to come up as the startup progresses and one cannot expect to resolve such deadlocks over a cup of coffee based on previous verbal understandings. It is pertinent to understand that even if your co-founder is your best friend, differences will arise in course of time and if nothing is done to address them, the startup will most likely take the fall.

Co-founders’ Agreement to the Rescue

The best solution to avoid abovementioned issues is to have a co-founders’ agreement in place since the very inception. Co-Founders’ agreement is a formal written agreement amongst the co-founders pertaining to several key issues about running the business. It helps to prevent and settle disputes resulting from differences amongst founders. It clearly lays down the roles and responsibilities of the respective founders and establishes a robust system of management and dispute avoidance and settlement. Such an agreement should be put in place before incorporating any new venture. It should be drafted in such a manner that there is no scope for ambiguity. It offers an opportunity to the founders involved in the startup to have honest conversations about their goals and aspirations so that later on, as the startup grows, there are no conflicts, both professional and personal.

Apart from ensuring smooth functioning of the business, the founders agreement also serves as an important document for the investors to understand the inter se roles and responsibilities of the founders. It indicates the governance model of the startup and plays a vital role in creating an impression on the investors.

Important Clauses

The contents of the co-founders’ agreement are based on understanding arrived by the founders. However, certain standard clauses are a must in such agreements.

• Defining the Business: It is important to define the vision and mission of the business and what targets it seeks to achieve over a period of time.

• Nature and type of business entity: The co-founder’s agreement should clearly describe the nature and type of business entity the founders are willing to incorporate. While deciding the same, the founders shall keep in mind their long term and short-term goals with respect to the business.

• Assigning Roles and Responsibilities: If all the founders have same or overlapping roles in the business, there is bound to be chaos. Therefore, it is important to assign clear roles and responsibilities to each founder depending on their area of expertise. For example, roles can be divided into operations, marketing, finance and so on. If each founder knows what is expected of him, he will be more efficient. Clear demarcation of roles also develops a system of accountability where would be easier to identify the specific responsibility for a particular task that is supposed to be performed by a particular founder

• Ownership Structure: The founders agreement should clearly describe the structure of ownership of the startup. This includes the percentage or number of equity shares held by each founder in case of a company or the percentage of initial contribution committed to be infused by each founder. It can be based on the particular founder’s involvement in the startup or the amount of capital invested by him. It is important to be clear about this provision in the initial stage itself to avoid any potential future conflicts among the founders.

• Transfer of Shares: It is important to lay down some restrictions on transfer of shares by founders. There can be concept of a lock-in period of certain years during which the founders cannot transfer their shares to any third party. This provision should clarify what happens if a founder transfers his shares before the lock-in period ends. It should also address whether a founder can transfer his shares to third parties. Provisions such as right of first refusal can be incorporated to give preference to the existing founders in transfer of shares. In case a founder leaves the company, the agreement should spell out how his shares will be treated- can he continue to hold the shares or will the company buy back his shares and at what value? The procedure for issuing new shares should also be laid down. All these issues should be discussed and put down in the agreement before commencing business to avoid unnecessary conflicts later on. A classic example is that of Facebook. During the initial stages when Facebook required funding and was trying to attract investors, Mark Zuckerberg diluted the equity shareholding of one of its co-founder’s, Eduardo Saverin. This led to a bitter lawsuit, which is depicted in the movie The Social Network. Though the case was eventually settled, Saverin got 5% equity in the company, which he continues to hold.

• Decisions: An important tool of resolving conflicts is to establish a decision-making procedure. For example, if a voting system is adopted, it should be clarified if all the votes will carry equal weight. What happens in case of a deadlock? Will any of the founders have a casting vote? In such a situation, can an external member be called upon to resolve the deadlock? There can be business decisions that may not warrant decision-making through voting. Situations such as these have to be envisaged at the initial stage. Should an actual eventuality arise, there will be a set mechanism in place to guide the founders.

• Compensation: The agreement should clearly lay down the scheme of compensation- which founder should get how much and how will the amount be determined?

• Assignment of IPR: IP can add a boost to the valuation of a company and is a very valuable asset. As a startup grows, it creates intellectual property, which should be protected. IPRs should be assigned to the company and not to any individual. This holds for the founders as well the employees of the company. If the company engages the services of a third party to create an IP, the founders should ensure that the IPRs vest with the company.

• Removal of a Founder: This clause lists the circumstances under which a founder can be removed from the company. Some of the grounds include sexual harassment, misappropriation of funds and taking up alternate employment. It should also be made clear as to what happens to the ownership and other interests in case a founder is removed.

• Non-compete: It should be agreed beforehand that while part of the company, a founder shall not engage in activities that are in conflict with the company. In case a founder decides to exit the company, he shall not engage in a competitive business for a certain number of years after his exit. In order for this provision to be effective, it is important to distinctly define the business in the initial clauses of the agreement.

• Confidentiality: Including a confidentiality clause in the co-founders’ agreement places an obligation on the founders to protect sensitive business information. Therefore, it should be drafted deftly to include any such information that the company seeks to protect.

• Dispute Settlement: This clause prescribes the mode of settlement of disputes, in case one arises between the founders. Doing so ensures that a large amount of time is not lost in settling the dispute if the parties cannot decide on the agreed mode of resolution. Generally, arbitration is preferred due to its various advantages over litigation.

Besides avoiding conflicts between founders, a co-founders’ agreement serves as an important instrument for the investors to gauge the management of the company before they invest in it. In the absence of such a founders agreement, an investor may not be very keen to put his money in a startup which does not have a formal system of management agreed to by its founders. Thus, a co-founders’ agreement also tells the investors that the startup has a robust governance system capable of dealing with issues that it may face at a later stage. All these points that have been discussed make it imperative for the founders to have a formal, written founders agreement before they approach investors for funding their startup.