Article by Kapil Karnawat
Company founders, at a very early stage of business, in fact even before incorporation, should enter into an agreement which governs the nature and functioning of their business. This is extremely important especially for businesses which are starting to operate but has not yet been incorporated.
After incorporation, many of the issues discussed here will be taken care of by the incorporation documents such as Articles of Association. The purpose of the agreement is to establish the understanding the co-founders have regarding the functioning of their company and relationship and obligation between co-founders legally binding through a formally written agreement. Such an agreement is called the co-founder’s agreement.
The formation of such an agreement requires an open discussion between the partners regarding their apprehensions, fears, outlook, aspirations and all arrangements involving the start up. The objective of the agreement is to minimize the possibility of debilitating surprises in the future when the company is functional in terms of inter co-founder relationship.
If you have a startup which is in a pre-incorporation stage, or if you just have an idea and it is co-founded, it is a great time to read this article and think of some of the issues described here.
ESSENTIALS OF A CO-FOUNDER’S AGREEMENT
There are certain essential elements that every co-founder’s agreement must address. They include the following:
BUSINESS DEFINITION AND MILESTONES (CLARITY)
Defining the potential venture of the company is very important. The definition can be as long as the founders please till the time they are certain that they have defined their business venture with clarity. It is also beneficial if the founders describe the milestones that need to be met along with the work that is required to be done.
The ownership element of the agreement deals with the equity which is held by each partner. Mostly, it addresses the percentage or number of shares which is held by each co-founder. Usually all co-founders have pro-rata voting rights, but that might change according to different arrangements. Different structures including the use of Veto powers today are quite common and should be considered.
Reaching an understanding on equity split can be one of the most challenging aspects. Each co-founder’s contribution and role should be taken into account, and may also depend on the investment made by different shareholders, as well as intellectual property brought on board. At the same time some room must also be left within the agreement if their initial division hasn’t been perfect. The division of ownership can be done in any of the following manners:
· Rule of N: N is the number of founders
The rule of N division involves equal division between the partners. This is easy to implement when the number of partners is an even number. However, it is slightly difficult to deliberate how the division would be in case of odd number of partners as a few shares or units will get left. Stating small detail like these within the agreement, helps make matters much easier. The problem with this method of division is that it doesn’t account for what is to be done if another partner is brought in in the future.
· On the basis of effort or capital contributions:
This decision involves a consideration of the efforts made by an individual in working or through his capital contribution and the division of ownership shares in this case is made in its proportion. The advantage is that this form is considered to be a fair form of division with the drawback that it doesn’t account for future ideas, efforts and contributions which may differ.
It involves the granting of shares or the right of the company to buy back shares. It may include conditions such as the passage of time, occurrence of certain events or the completion of certain tasks.
· Departure and dis-ownership:
The probability of departure of a partner is often overlooked by the founders at the beginning of their venture. However, it must be considered so that the co-founder’s agreement can clearly state what rights a founder will hold after his departure and how he can or cannot sell his shares. The objective is generally to limit the manner in which such a founder may sell away his shares. This is usually a big concern for the investors who may come on board at a later point as well as all the co-founders. This may also include certain clauses such as Non-Compete for safeguarding the organization.
Profits are another crucial aspect that must be deliberated over in the agreement. Division of profits can lead to gruesome conflicts if it hasn’t been specified in clear terms in the agreement. When a company or LLP is incorporated, such details will be taken care of in any case, but even at the pre-incorporation period, this is crucial to specify in order to avoid disputes later.
ROLES AND RESPONSIBILITIES
This element deals with what each individual will do, for what he will be responsible and the extent of his responsibility. Co-founders should keep in mind that one of the biggest reasons for co-founder disputes is over the role being played by each co-founder in growth of the business. While founders may play broad roles in the beginning of the company’s functioning, keeping the future in mind the significant role any individual may play in the future must be designated from the very beginning, in this agreement.
The objective behind this is not to reduce one’s role to a certain aspect, rather to have a specified role in the event that one is torn between two tasks. At the same time the roles shouldn’t be unchangeable because with the growth of the individuals will come to occupy varying roles. So, the decision-making procedures should allow for redefining of the roles as and when it is felt necessary by the founders.
Roles mustn’t be left to assumptions. One co-founder may hold a different opinion regarding his role from the other. In this manner undefined roles usually turn ugly in the future of the company. This is why great emphasis is made on pre-defining the roles and responsibilities.
As a company grows the decisions are bound to become more and more complex. In order to avoid a standstill through a conflict it has been suggested that the co-founder’s agreement clearly mention how decisions are to be made. The agreement should mention not only how substantial decisions are to be made but also how simple decisions are to be made. Often, day-to-day decision making is allocated to a CEO who is appointed by the Shareholders of Board of Directors. Usually, in the beginning, all or some of the co-founders may play the role of directors, and later joined by investors directors if any investment is raised.
The agreement is also required to state the procedure which is to be adopted in the event that there is equal division for and against a decision. Whether or not any individual would be granted an extra vote in this case must be stated. In case such an individual is granted the vote, it should me mentioned how such an individual would be chosen and consequently how the decision will be made.
FIRING OF A FOUNDER
A sensitive issue is regarding the firing of any founder. But the founders mustn’t shy away from this detail. How and in which event may a founder be fired is a crucial issue and it must be addressed in the agreement, otherwise there will be endless conflicts over such a matter. Co-founders should try and lay down the circumstances under which all of them agree that the ouster of a founder would be justified. The idea behind this is that in the event any of the co-founders does actually go ahead and do any such specified act, which is not in the benefit for the organization, then he can be fired. These circumstances will include commission of a fraud on the company and other co-founders, prolonged absence from work, illness or insanity which prevents them from carrying out regular duties or even insolvency.
It is also helpful if the co-founders state any values or factors that they will adhere to while making any decisions of the company.
The partners must also specify within the agreement the method which is to be adopted if disputes arise amongst them which they can’t resolve on their own. The common method is to go for arbitration, bringing in a neutral party, etc. If the method to be adopted in case of a conflict is already specified it makes matters easier for the future.
A non-compete clause is very important to ensure that founders do not branch out and start their own businesses and compete with the original business Similarly, one may require the founders to enter into a separate employment contract with the incorporated business once such incorporation is done. 3-5 years of non-compete is common.
There must be clauses in the contract imposing obligation on the co-founders to keep sensitive business-related matters confidential.
In the event, if a founder leaves, he or she should not solicit clients or employees of the business to other entities. This is a crucial aspect and must be addressed.
The compensation or salary that the founders will draw, and the determination of such compensation are both sensitive issues. One may feel that because he is investing larger sums or time into the company’s finances he is entitled to a larger remuneration. At the same time risk tolerance varies with each individual. It is better to address all such matters in the beginning than during the life of the company. It is also important to clarify in the agreement how expenses incurred in carrying out the business or otherwise by co-founders will be approved and reimbursed.
APPOINTMENT AND REMOVAL OF CEO
The founders have to agree on how a CEO can be appointed and removed. Usually this will be done by the Board of Directors and each founder will have a single vote. The voting may also be pro-rate to shareholding. In any case, the method must be written down in the agreement.
LOAN FROM FOUNDERS
It should be clarified how loan received from founders will be treated. It may be paid back with or without interest, or may be compensated by issuing shares of the incorporated entity. This is a common point of dispute, as founders often have to loan money to a fledgling business without investors from time to time to keep it afloat, and founders lending money in this way may feel that their contribution to the business is not being justly rewarded unless it is dealt with in the Co-Founders Agreement.
INDUCTION OF NEW CO-FOUNDERS
Induction of new co-founders can be very sensitive unless there is a clear agreement on the same. It can be expected that some founders may leave and must be replaced and even if no one leaves, it makes sense to take in new co-founders. This should not become a bone of contention between co-founders and lead to decision paralysis or disputes, especially since induction of new co-founder by giving such person equity in the business will mean reduction of equity/ shareholding of other co-founders in the business.
EXIT IN CASE BUSINESS SHUTS DOWN – TERMINATION
In what circumstances will the co-founder’s agreement be terminated? What if the business does not take off and becomes unviable? How will founders distribute assets, liabilities and any money left in the business? These questions must be answered in the agreement providing for each possibility as far as possible.
Who will have the authority to sign cheques? Who can approach investors or enter into important contracts on behalf of the business? It would be a good idea to clarify these issues in the agreement especially if the business is yet to be incorporated.
There will be other aspects to be addressed in such an agreement depending on nature of business and specific circumstances. There will also be many boilerplate clauses (such as entirety of agreement, Act of God etc.) that are routinely inserted in such contracts.
In few cases, sometime good business idea or stable business ventures, start failing not because of fundamental reason / factors like macro-economic changes, lack of hard work, lack of funding, disruptive competition, etc. but matters like Internal conflicts, ambiguity on decision matrix, rift between the owners etc. This can be avoided by mere executing simple document like Founder’s Agreement. It also helps leaders of business to guide entire team a clear vision way forward for sustainable growth more effectively and efficiently.
Happy Healthy Growing business time to all my dear connections. Good luck.Connect