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Founders’ Agreement: Why is it Essential?

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Founders’ agreement is a very important factor to look at to build a solid foundation before taking the next step with the business concerned. It is, in fact, the cornerstone of any successful business. So, what is Founders’ Agreement all about? It is said – ‘Starting a company with co-founders is synonymous to getting married’. One founder sees something special in the co-founder and believes there is a potential for a mutually beneficial relationship. This association of mind or the ‘consensus ad idem’ are serious commitments with several key matters which are important to be deliberated upon when taking the plunge for a long-term commitment.

‘Founders’ agreement’ is a generic term used for the agreements between the founders of the company that addresses the relationships, responsibilities of the co-founders in the company. It can be coherently defined as “a structured agreement between founders on matters that their business might face in the future.

It is also known by different sobriquets like shareholders agreement, operating agreement, founders shareholders agreement, depending on whether the company has been formally incorporated or not. The important objective of a founders’ agreement is to avoid any conflict, misunderstandings and disputes in the future.

CoFounders Agreement

When Is The Right Time To Enter Into A Founders’ Agreement?

The adages – ‘The sooner the better’ and ‘Better late than never’, holds perfect when it comes to founders’ agreement. To start with, at an early stage, an informal document is important to be prepared by either of the co-founder to sketch the contours and foundation of the relationship. It is not a legally binding contract but a written agreement. It might not be legally binding, but a well-done founders’ agreement will protect the co-founder concerned in case a dispute arises in future.

Founders’ Agreement: The Essentials

When you are starting a business with a co-founder, it is important that the common goals are laid down in a written form so as to avoid conflicts in the future. Both sides should prepare a list of important issues which could be discussed upon and a common ground is arrived at. Among other things, it is essential that the agreement contains the following –

  1. Name of the Company and its Founders – This is the basic part of the founders’ agreement. The name of the company and the name of the founders must be specifically mentioned in the initial agreement.
  2. Shares in the Company – The founders’ agreement must include the precise number of shares each founder will hold/is holding. This should also be translated in the form of a percentage for ease of understanding like in a company named ‘XYZ’ founded by A & B, out of 2 million designated shares, A holds 1.1 million shares and B holds the remaining 0.9 million shares which translates to A holding 55% of the company while B holding the remaining 45%.
  3. Roles and Responsibilities – Defining roles and responsibilities creates a ‘system of accountability’. Accountability does not only help in determining performance of the co-founder concerned but also goes on to decide compensation/equity depending on the performance. Delineating responsibilities helps avoid confusion and pandemonium altogether. It is also important to note that defining roles and responsibilities may seem to be unnecessary at an early stage when the co-founders may be involved in handling multiple profiles. Hence, it becomes important to identify the duties of each founder to avoid miscommunication so that each person can be held accountable with respect to their portfolios. Another relevant aspect that must be addressed in the founders’ agreement is whether the co-founder(s) concerned will devote his/her time part-time or full-time. This is important because many startup co-founders choose to continue with their jobs as a fallback option for when their startups don’t work. This must be cleared out so that there is no conflict in future regarding devotion of time in the concerned startup. In short, the agreement must contain what the co-founders do and how decisions are made.
  4. Intellectual Property – This is one of the most important clauses which must be included in the founders’ agreement as to ‘who owns the product’? It is a critical asset which can be either make or break for the company. It is not necessary that both the co-founders together develop the product. Either of them might be the one responsible for developing the product. For example, in a proposed IT company, one founder is a programmer and the other co-founder is a sales and marketing expert. Hence, the founder who is a programmer is involved in product development and the other is involved in sales.
    Therefore, it is important to make it clear in the agreement that the IP rights do not belong to a particular co-founder(s) and is actually a product of the company. So, if a co-founder(s) leaves, the product concerned remains with the company and not the parting co-founder. This is done because no one founder can dictate their terms to the other and in case if he/she leaves, the ownership remains with the company and not with the individual concerned.
  5. Ownership and Vesting – This is also an important essential to be considered in the framing of a founders’ agreement. This clause can be simply translated to – ‘who gets what?’. The shares of the company can be either equally divided among the founders or on the basis of a number of factors including who came up with the idea, the amount of time and capital invested by each co-founder, involvement of the co-founder in the company’s daily affairs.
    Another related topic to be addressed is the vesting of shares allocated to the co-founder(s). Earlier, it was common for the co-founder(s) to receive all the allocated shares immediately and he/she becomes the absolute owner of the shares with no pre-conditions attached. Nothing could be done about it once this is done. Hence, vesting of shares came into trend which makes the actual ownership of the shares contingent on each co-founder’s commitment to the organization.
  6. Termination Clauses – There can be a possibility where a co-founder has been under-performing consistently and needs to be let go. No matter how sensitive this is, but this factor must be discussed about with the co-founder(s) candidly. The co-founders should lay down the rules and lay down the circumstances which are agreeable to all that the termination of a particular co-founder is justified. For instance, commission of a fraud, prolonged absence from work due to illness, insanity, misuse of authority or even insolvency.
  7. Conflict Resolution – The co-founders must discuss the method of dispute resolution if any differences arise in future which cannot be resolved between themselves. The conflict resolution methods can be arbitration, mediation, conciliation etc. This makes the conflict resolution more organized and certain.
  8. Compensation/Remuneration – The compensation matters are crucial issues to be discussed about. It is always better to discuss about these issues at the starting itself than during the life of the company. Matters like reimbursement of expenses incurred in carrying out business should also be discussed with the co-founder(s).
  9. Confidentiality – It is important to have a clause imposing obligation on the co-founder(s) to maintain confidentiality on sensitive business matters.
  10. Non-Solicitation – This is an optional clause. This clause means, in the event a co-founder leaves he/she should not solicit the company’s clients to other businesses.

The above list is not exhaustive. The founders may include more clauses according to their needs. Some of the clauses are of such nature that the individual might be hesitant to talk about depending on the relationship level that he holds with the co-founder. But, for any business to succeed, it is important that such issues are discussed with candour than having a major disagreement down the road.

31 Aug, 16

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