Overview
Starting a business of your own could be a beginning of an exciting journey for an entrepreneur, especially when he has been planning to launch a business of his own for a long time. Most of the co-founders make mistakes of ignoring things regarding the distribution of their mutual roles and responsibilities which later results in turmoil in their professional relationship. A Founder’s Agreement is usually agreed upon by writing the terms and conditions down with the help of a legal professional before the incorporation of the company and is further signed either at the time of incorporation process or before initiating the process of incorporation.
Therefore, a founder agreement is a legal contract between the co-founders of a business and covers important issues such as deciding ownership in the company, initial capital contribution, roles, and responsibilities of each Co-Founder regarding the business. Regardless of the amount of prior intimacy among the co-founders, it is always advised to have a founder’s agreement in place for the smooth and efficient running of the business.
Co-founders come together to work as a team for a variety of reasons such as employing each other’s unique skills like technology or managerial skills, connections, and networks around them. They could be family, friends, colleagues, or any professional acquaintances having a similar vision or goal, and wish to contribute to the fulfillment of their vision. As of 2021 & 2022, India is witnessing a large increase in the registration and growth of start-ups, a co-founder agreement has gained quite importance.
The importance of a founder’s agreement could be summarized under these points-
- It helps to set up the expectations and goals of all the co-founders and assignment of specific roles and responsibilities towards functioning and improvement in the business.
- It also acts as evidence for the safeguarding of interests in the events of a dispute between parties, but should always be in written contract rather than just being an oral contract
- It also sets the terms of engagement in a start-up of any person providing services either for or on behalf of the start-up;
- It also provides for the assignment of all the relevant intellectual property rights to the business;
- It includes conditions and provisions regarding any conditions or prohibitions regarding share transfers or transfer of interests in the business to avoid interference of an outsider in the key business decisions.
Founder’s Agreement vs Shareholders’ agreement-Is there any Difference between the two?
Though the terms Founder’s Agreement and a Shareholder’s Agreement are used interchangeably, there are some differences between the two. While a founders’ agreement provides a legal agreement between the co-founders looking to establish the key aspects of a business such as individual roles and responsibilities of the founders, % stake in the equity, vesting period of equity a shareholder agreement on the other hand standardizes the manner of business to be conducted between the shareholders in the company and is thus beneficial at the time of a company’s incorporation.
Thus, a co-founder Agreement is a form of Shareholder’s Agreement that is especially relevant in the early stages of the business, and the same gets replaced by a more advanced shareholders’ agreement in the later years with changes in the ownership and shareholders in the business.
Key Considerations while drafting a Founder’s Agreement
A co-founder agreement addresses the following matters as provided below-
i. Assignment of Roles and responsibilities- Since each co-founder brings his unique skill-sets, expertise in a particular field, and relevant experience to the business, it is important to decide the role & responsibilities of each party to set a working professional relationship. Different designations are assigned to each co-founder and each co-founder could be responsible for the sub-division of responsibilities and budget distribution for their area. Such business divisions may include finance, sales, operations, sales & marketing, etc. and the founders may choose a title that best describes their roles & responsibilities.
ii. Business strategies & long-term vision– Next, it is necessary to draw the business strategies and the goals to be achieved by the business in the coming years in a specific manner that will include a short term as well as long term business goals including milestones to be achieved, in terms of revenues or other targets and a comprehensive business plan could be later created subsequently and reviewed periodically. However, where the co-founders join together with a common goal and a business strategy is yet to be developed, it would be sufficient to lay down the goals.
iii. Ownership structure– Where the business entity is a company, the ownership in the company is defined by the % stake held or shares held by each shareholder in the company. Therefore, the co-founders may jointly agree on a % of shareholding for each of them taking into consideration their roles & responsibilities involved and the capital contribution made by them based on the initial subscription of shares through contribution to the initial paid-up capital of the company, which shall be mentioned in the agreement.
Further, the founders may also lay down the % of shareholding to be kept for an employee stock option pool (“ESOP”) to be credited to the future employees or even co-founders for any notable achievement or contribution made to the business. The founders may also decide upon the detailed terms & conditions regarding ESOPs such as eligibility criteria, schedule for vesting, and the number of stock options to be offered under a scheme authorized by the board of directors and the shareholders of the company, which can be structured after the incorporation of the business.
Additionally, the co-founders may also include reverse vesting provisions in the founder’s Agreement for the founders by putting some shares to be “earned” by a co-founder by achieving any milestone or through their prolonged engagement with the business. However, in the event of their failure, those unearned or unvested shares could be repurchased by the Board for nominal or no cost.
iv. Provisions regarding Business Decision making
In the day-to-day business operations, the company shall be required to make decisions on complex matters. For which the founder agreement shall state the manner of reaching decisions which may be either simple or complex, may be taken by the board of directors or through the shareholders of the company. The day–to–day decision-making is assigned to the Chief Executive Officer (CEO) who is appointed by the Board of Directors of the company. The founder’s agreement may also prescribe the procedure to be adopted in case of any deadlock in decision making.
It is to be noted that as per the Companies Act 2013, certain specific decisions require approval of the board of directors and in some cases of shareholders either through ordinary resolution or a special resolution to make key business decisions such as amendments in memorandum or articles of the company, increasing the authorized share capital, reduction of share capital, buy-back of shares, Lending & Borrowing, Related Party Transactions, etc while some decisions are within the purview of the Board of directors for which their composition could be determined after the incorporation of the business.
v. Transfer of ownership related provisions
Another important aspect to be considered to be included under the Founder’s Agreement is the rights & restrictions regarding the transfer of shares owned by the founders of the company. The co-founders may decide on a common lock-in –a period under a clause providing for a Lock-in-period until the expiry of which any co-founder is prohibited to transfer any shares owned by him in the company and a mechanism to deal with in such circumstances where a co-founder wishes to exit the company before the expiry of the lock-in period. For this, it is advisable to determine the method of valuation of the shares along with the anti-dilution rights attached to the shares.
If the Co-founders wish to put more restrictions to ensure that the shares of the company are not transferred to any outsider, they can provide a clause for pre-emptive rights. The right of first refusal will cause the shares to be transferred to any outsider only the offer to accept shares has been made to the existing shareholders and they have refused the offer. Therefore, on the expiry of the initial lock-in –period, in the event the founders wish to voluntarily transfer their shareholding either partially or completely, the other founders shall have a Right of First Refusal to purchase either all or part of the shares being offered either individually or jointly. If the founders deny accepting the whole part or any percentage is remaining, the founders could sell the remaining shares to any third party.
Furthermore, founders sometimes also additionally put a clause namely, Drag Along Rights in the Agreement, which could help the minority shareholders in their company to sell their shares or vote in favor of an acquisition-related transaction, if the start-up/business is acquired by some other business.
vi. Anti-dilution protection-
Some founders holding stakes that are significantly lesser than the other co-founders fear that in the event of raising finances for the business in the future the company, the shareholding will be diluted which will further lower their overall shareholding. Therefore, to afford protection from such dilution, the founders can put an anti-dilution clause in the Agreement, so that whenever a company receives investment in the future through equity financing, a founder possessing a minority stake in the company could be issued more shares through further issuance of the share capital at minimum prices or the founders holding majority stakes would help the minority shareholder to maintain his shareholding percentage in the company by transferring a portion of their shares.
vii. Protection of intellectual property of the business-
Intellectual Property rights registered and created by all the co-founders in the business could be registered and protected under the name of the company rather than any individual co-founder. Additionally, the co-founders may also enter into other equally important agreements such as employment agreements/ service contracts with the company after its incorporation under which IP protection could be more detailed in language for legal clarity. Since a new business has immense opportunities for discoveries and innovations that could come from anyone, the IP protection clause should extend to all the employees, consultants, and contractors of the company, and the concept of ‘Work for Hire’ must be articulated clearly in their respective agreements entered with the company.
viii. Employment
In general, the co-founders do devote their whole time to the business and fulfill the criteria of a full-time employee of the company. However, it is important to have a clear understanding between the co-founders regarding terms and conditions related to employment such as type of employment, designation, compensation, and benefits which shall be paid to each of the co-founders for their roles & responsibilities. The co-founders may mutually agree upon such terms and based on these a separate employment contract could be drawn for each employee describing detailed terms of employment and the benefits to be afforded in pursuance of the agreement.
Additionally, in the event of any co-founder leaving the company, the employment agreement could also provide a non-compete clause prohibiting any of the co-founders leaving the business to solicit clients or employees of the company to any other business entity.
ix. Non-compete /Strict Confidentiality Clause-
A founder’s agreement obligates each of the co-founders to uphold strict confidentiality related to business activities and to further excuse themselves from engaging in any business that conflicts with a similar business to the company. The agreement must put a restriction against engaging in any other business directly or indirectly that conflicts with the aims & objectives of the business during their association and for a certain number of years after the termination of the Agreement.
x. Removal of a founder-
As important as it is to lay the terms and conditions related to founder roles & responsibilities on the table, it is also important to discuss the exit or removal related conditions for the business founders. The events & circumstances which may lead to the removal of a founder include death, disability, underperformance, breach of law, sexual harassment, misappropriation of funds, charges of moral turpitude, etc that involves co-founders, including a mechanism for the procedure to be followed for the exit/removal of any such founder. Where such exit/removal is due to death or disability, a certain sum of compensation could be prescribed in the name of the founder/legal heirs.
Additionally, in all other cases except death & disability, the founders can decide on the factors involved in the consideration of an act of moral turpitude and the mechanism to be set out in place for deciding the transfer of shares held by such founder to the other co-founders or by the company at a discounted value.
xi. c
A founder’s Agreement should also mention provisions regarding the additional capital contributions made by the co-founders to ensure the expansion & growth of the business. Apart from this, the clause should contain other details such as the manner of such capital contribution (either debt financing or equity financing), the method of valuation of the equity in case of equity financing, and finally the applicable rate of interest to be paid by the company in case of debt financing.
xii. Value additions Made by the Founders
The co-founders may further agree upon the provisions regarding the issue of shares or share options to the co-founders for any value additions made by them through any intellectual property rights, technical know-how, marketing rights, or similar value additions in the company. Thus, the co-founders may decide upon various factors related to value additions such as the valuation method for assessing value, the period within which such valuations will be made, compensation to be paid for such value addition.
xiii. Dispute Resolution & Termination
Finally like any other business relationship, there may be disputes among the co-founders forcing them to even terminate the agreement. For which, the parties may decide upon the events which may result in disputes or termination of the agreement, i.e. any major business decision made by a founder without discussing it with the other co-founders, etc. For such events, the parties may mutually decide upon the mechanism to be followed for resolving any dispute cordially regarding the matters provided in the Agreement i.e. mediation, conciliation, and arbitration. Where the parties are unable to resolve their dispute through conciliation or mediation, they may decide on an independent third party arbitrator to decide the dispute along with the governing law and the exclusive jurisdiction of the courts to which the disputes under the Agreement may be referred in case of any further failure.
Conclusion
Therefore, co-founding a business by two or more founders of the business could be compared to a marriage that has a long-term commitment and challenges to overcome to sustain growth. Hence, it is necessary to have pre-defined roles & responsibilities with clarity of the work arrangements. When founders understand each other’s strengths, expertise, and weaknesses, they must strive to create a balance for a healthy working ecosystem, and there is little room for any disputes to take place. However, even there is any dispute, having a founder’s agreement in place to guide through the mechanisms for every situation brings continuity, strengthens business ties and commitments for a successful business venture and the entrepreneurial journey of each entrepreneur!
