Building a Strong Foundation: Founders Agreements and Startup Success
What is a Founders Agreement?
A founder’s agreement sets out the rights and responsibilities, commitments and roles for each of the founders in a startup. Its purpose is to protect the interests of each of the founders and avoid potential conflict in the future. This is one of the first agreements that the founders of a startup should get in place, even before any legal entity is formally incorporated to operate the startup business.
Why is it important to have a Founders Agreement?
Founders of a new startup always begin their relationship with best intentions, but inevitably, as the business develops, circumstances will change, unforeseen events will occur, and disagreements will arise. One of the most common missteps by founders is not having those tricky conversations early on to agree on how decisions will be made and how conflict will be handled, and this may ultimately lead to the undoing of the whole business venture.
Regardless of how aligned the founders are in their vision and goals for the project, it is to the benefit of all parties that certain principles and mechanisms for running the business be set out from the beginning. The following are a few key issues which should be covered by a Founders Agreement:
1. Ownership and decision-making
The first thing a founder’s agreement does is clearly set out what is the ownership stake of each founder in the startup business. The founders agreement should also determine how decisions are to be made, in particular what will be the voting thresholds required for approving key decisions.
The founders should also agree on how the day-to-day management of the startup should be handled, including who will be appointed as legal representatives and the requirements for legally binding the startup company.
While the terms of the founders agreement are valid and binding between the founders, many of these provisions will then be reflected in the constitutional documents of the startup company.
2. Dispute Resolution
A founders agreement should establish rules for how disagreements are handled internally. For example, appropriate mechanisms should be agreed on how to handle “deadlock” situations, where no sufficient majority can be obtained to pass necessary decisions due to the disagreement between founders.
In cases where disputes cannot be resolved internally, founders may agree to adopt alternate conflict resolution mechanisms, such as mediation or arbitration, in order to avoid lengthy legal disputes through the court system.
3. Roles and responsibilities
Each founder in a startup offers different capabilities which are essential to the success of the project, whether those be technical capability, marketing ability, management experience, or cold hard cash. A Founders Agreement should define the roles and responsibilities of each of the founders towards the startup company, so that everyone’s expectations are aligned and each founder knows what is required of them.
A founders agreement should also establish whether founders will receive compensation for performing their duties and how such compensation will be determined.
In order to avoid founders losing interest and not meeting their commitments to the project, mechanisms for holding founders accountable to their commitments can be agreed on, such as rules for adjusting compensation, management responsibilities or even equity based on agreed-upon performance targets.
4. Exclusivity obligations
It should be clear what are the exclusivity obligations of the founders. Are founders allowed to hold shares in other companies in the same or similar business sectors? Are they allowed to provide consulting services to potential competitors? Are they required to devote their full time to the project? The answer to these questions will vary based on the profile of the project and of the founders, but the important thing is to be clear regarding expectations from the start.
It should also be made clear that any intellectual property created by the founders for the benefit of the business venture is to be exclusively transferred to and owned by the startup company. This will avoid disputes regarding IP ownership IP in case a founder exits the project.
5. Share transfers and exits
Founders should agree on what will happen when fundraising opportunities arise or when there is a proposed transfer of shares in the startup company. Examples of typical clauses for protecting different shareholders rights are:
Rights of First Refusal: Existing shareholders have the preference right to acquire any shares that are for sale (avoids shares of the company being transferred to third parties);
Drag-along rights: Majority shareholders who wish to sell shares may require minority shareholders to sell their shares on equivalent terms (avoids minority shareholders from blocking a deal by refusing to sell); and
Tag-along rights: Gives minority shareholders the right to join in a sale of shares by a majority shareholder on equivalent terms (protects minority shareholders from being excluded from deals).
Finally, appropriate mechanisms should be agreed upon for situations where founders want or need to fully exit the business, and founders should agree to remain bound by confidentiality, non-compete, and non-solicitation obligations in such an event.
This is the second in a series of articles offering practical legal tips for young entrepreneurs, to be published by the author in co-operation with the Macao Young Entrepreneur Incubation Centre, where he provides mentorship and consultation for its members.
