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When a small group of founders get together and start a new venture, they will need to discuss the terms of the business relationship with one another. How are work responsibilities shared among founders? How is equity split among them? What would happen if one of the founders wants to leave? What is the decision-making process for various management actions? They may need to discuss and negotiate on other issues, as well.
What is a founders’ agreement?
When the agreed-upon terms of the business relationship are put in writing, it is a founder’s agreement. It could be a stand-alone document, or it could be integrated into an LLC operating agreement or a stockholder agreement. The founders’ agreement will define the roles and responsibilities of the founders, define the ownership structure, allocate control and deal with potential sources of conflict.
In reality, founders often start ventures with informal agreements, lacking in-depth conversations or documentation about their expectations. However, a thorough founders’ agreement is necessary in order to raise outside financing from professional investors, and it can mitigate many of the difficult issues a startup may face.
Here are some founders’ agreement ideas that will help your startup grow, and avoid common founder-related issues.
1. Define the expectations for each founder’s responsibilities and set up procedures to deal with potential issues
In general, founders are partners who join a venture from the beginning, investing sweat equity, contributing work that builds the value of the startup. However, some partners only contribute ideas, key designs, or cash, and may not be required to work.
In whatever way responsibilities are divided among founders, the understanding should be mutual and clearly stated in a founders’ agreement. The agreement can state what minimum engagement is necessary, whether it is a number of hours or a substantive contribution toward the company’s growth. When the minimum is not met, a defaulting founder can be given a cure period to correct his actions.
The agreement can also allow buybacks of the defaulting founder’s equity if he fails to cure the default within a given period, or commits wrong against the company or its other founders.
When founders set clear expectations at the onset of a startup, and prepare procedures to deal with defaults, it is much easier to resolve conflicts. This is the greatest benefit of a founders’ agreement.
2. Vesting and buyback procedures ensure every founder is working together toward an established goal
Most startups begin with a small capitalization and rely on the founders’ efforts to build value. Therefore, a startup typically grants equity to founders with a vesting schedule, which requires each founder to contribute effort for a certain period of time in order to fully earn equity in the firm.
A vesting schedule can vary for different agreements, but the standard schedule for startups is a four-year vesting period with a one-year cliff. This means that a founder will fully retain all of his shares after four years. During the four-year period, the company can forfeit unvested shares or buy back at the initial purchase price if a founder leaves the company.
With a one-year cliff, no founder will be entitled to any shares if he leaves the company before its one-year anniversary. More equity may vest monthly, quarterly or annually thereafter, according to a schedule. The longer each founder stays with the company, the larger percentage of equity will be vested.
Vesting protects founders from each other and ensures they continue efforts to grow the business. A founder who was given 25% of the company, but then walks away after a few months, cannot claim 25% of the pie when the company is sold for $10 million later down the road.
There is also tax benefit for individual founders when they receive equity subject to vesting. By filing an 83(b) election within thirty days of the grant, a founder can be taxed on the value on the date the equity was granted, instead of the date the equity vests. Assuming the value of equity increases in the future, a founder can save tax by paying income on the small initial value of the equity.
Drafting vesting correctly is an important part of a founder’s agreement, which incentives everyone to contribute to the company.
3. Optimize ownership structure for future equity changes
One of the common mistakes founders make at the onset is hard-wiring equity interest into percentages.
Fixed percentage interests are hard to maintain when additional equity is issued, or if one of the owners leaves the company. Every time additional equity is issued, each founder should assign a certain share to a new person in order to keep percentages consistent. Otherwise, when one of the founders leaves, there will be questions or conflicts about how to keep the relative percentage among remaining founders fair.
Founders should issue equity in units—similar to shares of corporate stock—to the equivalent value of the desired percentage. This way, the percentage interest can move flexibly when changes are required in the equity structure.
Adding an anti-dilution provision creates unforeseen obstacles to a startup expecting to grow significantly in the future. Rounds of financing will inevitably dilute the founders’ equity, and anti-dilution could make it difficult to bring in other investors.
4. Provide mechanisms to deal with departing founders
The team that started the venture is not always the same team that will finish it. Founders can leave the company for various reasons. Death or bankruptcy can cause departure, but more often disagreement or loss of interest cause a founder to leave. Not everyone is cut out for the startup life, and a company needs to be prepared to continue its operation without interruption if a founder leaves.
If the company has an equity vesting policy in place, it is much easier to recover stocks that are not fully vested from a departing founder. Beyond the vesting period, the company can have a buy-sell agreement that specifies the manner for buying back equity. The company’s right to buy back equity from former founders is an important component of a founders’ agreement.
Startup companies should also put an Intellectual Property Assignment Agreement in place, which transfers all intellectual property rights to the company, making certain a founder does not leave and take all of his intellectual property with him.
5. Avoid these common mistakes as you set up decision-making processes
Founders face a wide range of decisions in managing their startups. Deciding upfront how the decisions are made can preclude headaches and paralyzing confrontations among founders. Here are some of the common mistakes founders can avoid, in order to create effective decision-making processes.
- Failure to divide duties based on founders’ skills. Different founders come with different skillsets. Instead of requiring all founders to participate in all decisions, founders should divide decision-making duties based on specialties. One or more founder can make all finance-related decisions, while technically skilled founders can make technical decisions. While founders trust each other to make decisions in their respective areas, they can reserve the right to veto if they don’t agree the decision will serve the company.
- Inconsistent decision thresholds. A comprehensive operating agreement or founders’ agreement will provide parameters for the many different decisions that need to be made. It is a good idea to have consistency about who (the board, majority or managers) will decide what with what percentage.
- Requiring 100% consent. When a decision requires the 100% consent of all equity owners, any minority owner will have inordinate veto power. For example, a partner who left the company with 5% equity could still have a lot of influence over how the company is run. You can require a supermajority (60% – 90%) instead of 100% consent to avoid this problem.
- Failure to articulate deadlock provisions. Even if decision-making processes are well established, there may be issues wherein founders disagree and cannot move forward. Adding a deadlock provision can help by specifying how to get past the situation.
6. Provide dispute resolution tools
It would be best if founders had conversations about their expectations and set procedures in writing to minimize disputes. However, disagreements can happen among founders with different expertise and strong character, and some of them cannot be resolved by trust and empathy alone.
It is true that a large number of startups fail due to co-founder disputes. Founders often get embroiled in lawsuits due to their unresolved differences, like the case of Snapchat – Business Co-founder displute.
A founders’ agreement can provide dispute resolution measures to be used when founders cannot negotiate a solution to a problem. Bringing in a third party mediator or arbitrator is a popular way to reach a settlement without going to court.
Questions about Founders’ Agreement? Contact Jiah Kim & Associates
If you are starting a business and would like help choosing the best jurisdiction to Founders’ Agreement, we encourage you to contact us for a confidential consultation. To schedule an appointment at Jiah Kim & Associates, call (646) 389-5065 or inquire online today.
This blog post is written for educational and general information purposes only, and does not constitute specific legal advice. You understand that there is no attorney-client relationship between you and the blog publisher. This blog should not be used as a substitute for competent legal advice from a licensed professional attorney in your state.
This post is also available in: Spanish