In the excitement and enthusiasm of starting a new business, formalising agreements are often overlooked. Startup founders are often friends or acquaintances, and it is easy to fall into the trap of only discussing roles, responsibilities, ownership structures and other important matters verbally. This can be dangerous. People and things change – especially when money is involved. What happens if one of the founders wants out? Can they take the intellectual property with them? Do you all share in the profit equally? Do you all share responsibilities equally? Are there any restrictions on your shares? How will decision-making work? These are just some of the many issues that could arise between founders of a new business. That is why it is essential to have a founders agreement setting out all the relevant information to protect each founder’s interests and how they will work together to move the business forward. It can be challenging to decide what to include in your founders agreement. We will focus on the essential elements and ask questions that will assist you in determining what to include in your founders agreement.
1. What is a Founders Agreement?
2. Why is a Founders Agreement important?
3. What should you include in a Founders Agreement?
4. Basic steps to creating a Founders Agreement
5. Is there a difference between founders and shareholders agreements?
What is a Founders Agreement?
A founders agreement is a legal contract that governs the business relationships between the founding team. It sets out each founder’s rights, responsibilities, liabilities, and obligations. A founders agreement aligns the founding team and ensures they are all clear on their role in the venture. It is very similar to a shareholders’ agreement (and those terms are somewhat interchangeable), but founders agreements are a simpler version that you would typically put in place before your startup has given shares to non-founders, such as investors. A founders agreement should be entered into as early as possible and can even be signed before creating a legal entity. It helps to clarify each founder’s role, who owns the IP, what happens if a founder wants to exit, how disputes will be resolved, etc. It also signals to potential investors that you are serious about the business. Not having a contract in place to cover these matters can be a red flag to investors as it signals an increased potential for fallouts, disputes, misunderstandings and bad governance. On the other hand, having a well thought out and structured founders agreement in place at the right time can help with your fundraising by de-risking your startup from the perspective of potential investors and showcasing the thoughtful planning and management of the founders.
Why is a Founders Agreement important?
There are many reasons why a founders agreement is important, but a few key reasons include the following:
- It identifies and sets out the role of each founder from the beginning.
- It provides clear rules for resolving conflicts and disputes that may arise in running the startup.
- It sets out share transfer restrictions, such as pre-emption rights and rights of first refusal.
- Most founders agreements will include a vesting schedule. Vesting schedules protects the startup and other founders against a founder leaving without fully contributing, but keeping all their shares. It also incentivises founders to stay.
- It sets out a set of matters that can only be decided by all founders (key matters such as capital raising, exits, capex, opex etc.).
What should you include in a Founders Agreement?
Whilst each founders agreement can be tailored to your startup’s specific situation, certain basics should always be included in a founders agreement.
Set out the names and full details of all the founders. Your agreement should also set out the equity ownership of each founder. Equity often equates to incentives to stay involved in the business.
A summary of what the business of the startup will be.
You need to determine your intellectual property and clearly define it in the founders agreement. This is what your business is all about! You must define who it belongs to. Usually, anything created at work or during working hours is considered company IP. There will typically be an IP assignment clause confirming that business-related IP belongs to the company, or a separate IP assignment agreement.
Transfer of ownership provisions
Are founders permitted to transfer their shares right away or is there a lock-up period? Should a founder wish to transfer their ownership, is there a right of the first refusal, i.e., must it be offered to other founders first? How will exits be governed, e.g. can a majority of the founders force a sale or must they all agree?
Who is contributing what? Are the contributions cash or in-kind (services, experience etc.)? It’s good to put a monetary value on each founder s initial contribution, even if it’s in-kind. This will help assess valuation for any buy-backs that may need to happen under the vesting provisions.
Roles and responsibilities
A founding team often has diverse skill sets. Your agreement should define roles and responsibilities meticulously. It is essential to know who is responsible for what. Who is the CEO, and what is their role, etc.? Who will perform the tasks that no one wants to be responsible for? Defining roles also ensures that each founder sticks to their key area and doesn’t step into another founders lane. The agreement should ideally also set out the process for when a founder is not performing their roles and responsibilities.
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Decision-making and dispute resolution
This provision is crucial since it will determine how significant decisions are made. What decisions can be made by a single individual? When is voting required? What matters are for the board and what matters are for the shareholders? Who is allowed to vote? Are voting rights based on a percentage of equity? Does any founder have a veto right at a shareholder level? What happens in a deadlock? What will the board of directors look like? Which founder will have a right to appoint directors and how many? How will the board vote and will there be any veto matters at a board level? It is important to include a method for dispute resolution. It will avoid uncertainty and save time and money. Will disputes be referred to mediation, arbitration, or other forms of dispute resolution? Who carries the costs? Without a dispute resolution clause, deadlocks can easily lead to the termination of the venture.
Anything can happen. A founder can burnout, go bankrupt, find a better option, or the co-founders might decide they want a founder to be removed. You should deal with these possibilities in your founders agreement. Vesting provisions are great ways to protect the business and ensure long-term commitment from founders. A vesting schedule governs how and when each co-founder gets their shares or equity over time rather than immediately and what happens if they leave or are removed before the end of the vesting period. For founders, this is typically structured as ‘reverse vesting’, meaning that all the shares are still issued to each founder from the start, but a decreasing proportion of them are subject to being bought-back by the company over the vesting period. Schedules can be based on time or performance (‘trigger events’ or reached milestones) and should outline the period that founders need to stay in the business if they want to reach their full earning potential. It essentially sets out how founders “earn” their equity over a period of time, on performance, or reaching targets. Vesting cliffs provide for periods when no equity or shares vest. It mitigates the risk of a founder holding on to equity whilst not adding value to the business. For example, each founder will vest an equal percentage of equity over four years, with a one-year cliff. So, the founder must stay with the business for at least 12 months before any of their shares will vest. When drawing up your vesting schedule, you should specify how shares or share options are allocated to founders. Consider issues such as whether vesting is based on continued participation in the business. What happens to the vesting schedule if the business is sold? What happens if a founder suddenly leaves, etc.? What value will the founder’s shares be bough-back if they do leave? Under what circumstances would the founder be considered a good leaver versus a bad leaver? An effective vesting schedule incentivises co-founders to stay and protects the business in case one leaves.
Confidentiality, non-disclosure and non-competes
A confidentiality clause is essential to a founders agreement. It ensures the business ideas and concept remain confidential. The agreement should also indicate if a founder is restricted from joining or setting up a competitor’s business. Non-disclosures and non-competes should be carefully drafted. These can also be set out in a separate agreement (e.g. a non-compete agreement).
Dissolution and termination clauses
Although you may believe you do not need to think about what will happen if the venture fails, including dissolution and termination clauses is essential. Specify what events or circumstances might lead to the dissolution of the venture. Explain the winding-up process and any distributions if the venture is terminated. What happens if one of the founders wants to take the idea and try again? Dealing with dissolution or termination upfront can prevent legal battles in the unfortunate event of dissolution.
Governing law and dispute resolution
The founders should designate a law that will govern any disputes that may arise between parties, the jurisdiction where disputes will be heard and the method of dispute resolution (e.g. English law and English courts, or English law and ICC arbitration held in London). Your startup’s future success or failure can depend on your founders agreement. These are just some of the provisions you should consider and questions you should ask when drafting a founders agreement. You can generate a founders agreement on Clara in just a few clicks.
Basic steps to creating a Founders Agreement
- Choose a format
You want a founders agreement that best suits the founders and the startup.
- Take your time
Allocate sufficient time to think through each aspect of the agreement, from formation to termination and everything in between. Don’t get personal; keep it professional.
- Get legal advice
A founders agreement is a legally binding contract. Consult with a lawyer to review your agreement. Clara can help connect you with one of our preferred legal partners. Get some tax guidance to check any tax implications arising from the agreement (vesting, in particular).
- Get financial advice
Besides legal implications, a founders agreement can have significant financial consequences for the founders. Consult with financial advisors and other entrepreneurs with experience.
- Review individually
Each founder should review the agreement and consider how it affects them. Consult your lawyer for clarity and guidance if you are unsure or uncomfortable with a provision. Once signed, the terms of the agreement legally bind you.
Is there a difference between founders and shareholders agreements?
Although there might be overlaps between shareholders’ and founders agreements, they are separate documents. Founders agreements focus on establishing the basics, such as roles and responsibilities, equity ownership and vesting between founders before incorporation. In simple terms, it regulates the relationship between the founding members. It is relatively simple and suitable at the early stages. Shareholders’ agreements become more relevant when the company raises external funds and issues shares to investors. Expect your founders agreement to be replaced by a shareholders’ agreement once you carry out your first equity funding round.
A founders agreement should be one of the first important documents you sign when starting a new business venture. Don’t rely on friendships and informal agreements. There is too much at stake. To ensure that your interests and the venture’s interests are protected, you should seek expert advice and formalise your founders agreement at a very early stage.