Founders agreements are important documents for any startup.
They ensure that all the business founders understand their roles in the company, agree on how decisions will be made, how equity, assets and capital will be shared, as well as the rights, responsibilities, obligations and duties of each member of the startup.
Why You Need a Founders’ Agreement
If you’re planning to start a new business with another person, you need to make sure that you have a clear understanding of who owns what and what each party’s responsibilities are and how shares are going to vest with each party. This also includes things like who gets paid first, who has final say, and who takes care of what.
The main aim of a founders’ agreement is to avoid future disputes from cropping up. You might think that shall not happen, but you would be surprised as to how common this actually is.
When is a Founders’ Agreement Used | Instances when You Might Need a Founders’ Agreement
A example of how a founders’ agreement might come in handy is, if you and your partner started a company together and now want to dissolve it, you may need to create an agreement so that both of you know what each other’s obligations are and how much money you should receive from any liquidation proceeds.
The agreements vary in length and detail depending on their purpose but typically include:
- Who owns what shares
- How profits from the company will be divided
- Who pays for expenses such as rent or legal fees
- Who bears risk for failure in the business (such as paying employees if the company fails), etc.
How to Draft a Founders’ Agreement
A Founders’ Agreement is a legally binding contract between two or more people that sets out how their business will be run and what percentage each person will receive of ownership, as well as how the ownership will vest on the co-founders. It’s a very important document to draft, especially if you are looking to raise money and/or hire employees.
A good rule of thumb is to keep the Founders’ Agreement simple and short—about four pages long should suffice. You don’t want to get bogged down in legal jargon or details that are too complex for you or your investors to understand clearly, especially if you are drafting the agreement on your own.
Factors to Take into Consideration when Drafting a Founders’ Agreement
Here are some things to consider when drafting your Founders’ Agreement:
1. Scope of the Founders’ Agreement
The parties must be clear about the scope of the agreement, including any restrictions on the company’s activities.
2. If Possible, Ensure the Founders’ Agreement is Drafted by Experts
The drafting process should be overseen by an experienced attorney because certain provisions in a founders’ agreement may require specific legal expertise to draft properly and accurately.Ensure that all terms are clearly defined in advance so there are no surprises later on down the road. You would be surprised how easy it is to challenge the meaning of terms used in contracts, if they are not properly defined in the beginning of a contract.
- Related Read: 15 Essentials of all Contracts
3. Consider the Pros and Cons for each Founder.
Since the founders’ agreement is bound to put forward rights and responsibilities among the founders of the startup, it shall bring with it certain benefits and drawbacks that all the founders need to face. So, before you start drafting the agreement, it is suggested that you take a step back and think of how the agreement shall be providing you with as well as interfering with your rights in operating the startup.
4. Make sure that there are no conflicts of interest among the founders.
For example, if one member of your team owns a competing company or has worked at one before, he or she should be excluded from participating in any decision-making process related to his or her previous employer.
5. The type of business being formed.
If this is a new business idea, innovative business plan (make sure to SWOT and PESTLE test it), or an innovative business model or revenue model, it’s likely that there will be no existing precedent for what type of business legal structure would work best for this type of business.
There’s no guarantee that your chosen structure will be successful or even legal in your country — so it’s important to make sure you’re complying with local law as well as any applicable international treaties before proceeding with any agreements that could affect international trade or commerce (which can happen if an investor purchases shares in a foreign-based company).
Essential Terms and Clauses of a Founders’ Agreement
A founders’ agreement needs to cover four key areas –
- Roles and responsibilities of the founders of the startup;
- Rights of the founders and the rewards they can expect on attainment of key business milestones;
- Mandatory and optional obligations imposed and faced by founders of a startup;
- What happens during Contingencies occur.
If your agreement covers these areas in detail, then you need not worry about anything more.
However, to discover these areas in more depth and understand how essential terms and clauses are used in these agreements, let’s first look into how a founders’ agreement is structured.
#1. Who are the Founders of the Startup?
First, the agreement begins with who the founders of the startup are. This helps identify the participants of the agreement, ensuring the agreement is more foolproof and can not be called into question later on.
#2. When Shall the Agreement Start and When Shall It End?
In this regard, it is important to divide the co-founders’ rights and responsibilities. You may provide the vesting of the shares to last for around 5 years, after which share allocation between the two co-founders become permanent and in that regard, the agreement ceases to function.
However, the part wherein responsibilities are allocated between the co-founders should be perennial in nature. This will ensure the obligations and responsibilities of each co-founder remain as per the contract.
If required, feel free to amend the contract so as to add or subtract responsibilities from each of the tabs of the co-founders.
#3. Business Aim and Milestones
It is recommended that you keep this part of the contract not legally binding on either you or your co-founder. This is because as a startup, you need to continuously test out your business plan, business model and revenue model. Plus, if anything does not work out, you need to have the freedom to pivot your business strategy continuously.
However, establishing the company’s aims will help to build a strong business model. In addition to goals, the company’s values, mission, and work culture can be addressed.
#4. Function, Roles and Obligations undertaken by Each Co-Founder
Describing the founders’ duties will help to avoid confusion and waste. The contract may include equity and performance-based compensation criteria.
#5. Sharing of the Equity and Vesting Schedule of the Stock Should Be Mentioned
The stock breakdown shows the amount of funds, money invested, and other assets. The contract also specifies the style of operation, the names of the investors, and the parameters of the shareholder relationship.
Vesting refers to the amount of equity that can be awarded to the founder upon his / her exit. Describing the vesting schedule protects the corporate resources.
You need to incorporate this as it helps prevent awkward scenarios wherein your co-founder may leave immediately after you split your business into two parts with your co-founder.
Thus even without having to do any work whatsoever, he owns half of your company, just like that. Vesting helps prevent your co-founder from leaving immediately after allocation of shares.
A vesting period for co-founders should last around 4 years.
#6. Intellectual Property Rights Must Be Allocated in the Founders’ Agreement
Because creativity breeds innovation, all creative content used to establish a firm should be safeguarded and protected. Any intellectual property created as a result of the business must be registered by the firm, not the individual. As a result, establishing the full scope of intellectual property benefits in the agreement prevents piracy, theft, and counterfeiting.
It also helps protect the trademark of the business straight from the get-go as well as ensures any invention created by the startup gets patent protection that is bestowed to the startup and not to its founders.
Of course, intellectual property laws do allow you to protect your intellectual property rights as trade secrets as well.
#7. Remuneration and Rewards Expected by the Founders
An agreement’s compensation describes salary, performance bonuses, stock options, and other benefits. Remuneration specifics in a founders’ agreement aid in the definition of revenues, gross profits, payment methods and times, and sales. The agreement can also specify who has the authority to approve stock and debt.
#8. Dispute Resolution
In this area, you need to mention how you intend to solve a dispute, if any crops up between you and your co-founder. You can add in arbitration clauses or mediation clauses, so as to make those mandatory in resolving disputes, rather than having to take recourse to litigation.
#9. Termination Clause of the Agreement
Of course, you must offer a way out for both you as well as your other co-founders to leave the company. For that, a termination clause is essential.
If you don’t want your co-founder to sell his shares to any outsider, you might stipulate in the contract that your co-founder has to offer you for buying his shares at current market rates.
Wrapping it Up
That’s all regarding what is a founders’ agreement and how to draft one.
If you have any questions, do leave it down in the comments or send me an email and I will get back to you. Also, here’s a template of a founders’ agreement that you can use for your requirements as well.