Co- Founders Agreement : All you need to know

  • August 4, 2017
  • 10:25 am
  • Vaishnavi Sen

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

Defining the potential venture of the company is very important. The definition can be in as many words as the founders please as long as 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.

 

OWNERSHIP

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 will have pro-rata voting rights, but it is possible to have a different arrangement as well. Veto powers are quite common, and should be considered.

Reaching an understanding on equity split can be one of the most challenging aspects. Each co-founders contribution and role should be taken into account. It may 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 in the event that 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. If this small detail is also decided and stated by the co-founders within the agreement, matters can be made 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 division of ownership shares is made in its proportion. The advantage is that it is considered to be a fair form of division but the disadvantage is that it doesn’t account for future ideas, efforts and contributions which may increase.

Vesting: 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.

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 on.

 

 ROLES AND RESPONSIBILITIES

This element deals with what each individual will do, for what he will be responsible and the extent of this responsibility. Co-founders should keep in mind that one of the biggest reasons for con-founder disputes is over the role being played by co-founders 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.

 

DECISION-MAKING

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. If this is done then it must also be 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 that any of the co-founders does actually go ahead and do any such specified act, 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.

 

CONFLICT RESOLUTION

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.

 

NON – COMPETE

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.

 

CONFIDENTIALITY

There must be clauses in the contract imposing obligation on the co-founders to keep sensitive business related matters confidential.

 

NON-SOLICIT

In the event that a founder leaves, he or she should not solicit clients or employees of the business to other entities. This is a crucial aspect and has to be addressed.

 

COMPENSATION

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 MEMBERS

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 nd have to be replaced and even if no one leaves, it may make 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-founders 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.

 

IMPORTANT AUTHORITIES

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.

 

OTHER ELEMENTS

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.

PREVENTING CO FOUNDERS DISPUTES

One of the best ways to minimise the probability of co-founder dispute is by drafting a well-balanced agreement respecting the interest of all the parties to the agreement while laying down a dispute mechanism simultaneously. Though there exist Memorandum and Article of Association which usually governs the relationship between the stakeholders, it could take shape as company’s bylaws or a partnership agreement, etc. The clauses to emphasise on while entering into a Co-Founders Agreement in order to minimise the dispute are:untitled-design

Contribution and Ownership of Each Partner to the Firm: It is important to mention clearly the ownership pattern of each partner addressing the percentage and number of shares held individually. Depending upon the number of shares held, co-founders are assigned their voting rights which also if clearly mentioned could avert serious complications. In the case of Housing.com, the shareholding pattern with regard to the capital invested, the effort made by the partners was missing in the agreement. Also, no provision with regard to the vesting of shares was explicitly mentioned as such.

Business Decisions:  In the benefit of the Company’s interest, it is essential to lay down a mechanism to take the decisions smoothly in order move forward. The decision-making power should be shared depending upon the shareholding pattern of each co-founder, but the mere presence of such mechanism can avert many future disputes. In Housing.com dispute, with a total number of 12 co-founders, only two were given recognition by the Board. Since they lacked the majority in the board, the decisions making mechanism had taken a hit. Therefore, if it is made clear in the co-founders’ agreement the decision-making power vested in every individual, it would be hassle free for the management to take decisions.download-1

In the event of Co-Founder leaving the Company or being fired: In case a Co-Founder wishes to leave the company or is being fired as a result of Co-Founder dispute, it is essential to mention the right that they will enjoy after their exit. Certain exit rights could be included in the Agreement in order to protect the company such as:

Right of First Refusal – A right of first refusal could be established giving certain parties an option to buy the shares being sold by the existing co-founder before offering it to a third party. In Housing.com conflict, Mr Yadav was certainly not obligated to offer his shares to the Board of offering it to a 3rd party. Therefore, a strong exit clause from the agreement was missing.

Tag Along Rights – In the event where a Co-Founder exits the company, tag along rights could be given to the other Co-Founders, giving them the option to leave the Company on the similar negotiated terms.

Drag Along Rights – On a similar event of a Co-Founder exiting a company, drag along right could ask another Shareholder/Co-Founder to participate in the transaction.

Intellectual Property: Equity distribution amongst the co-founders is based on the capital brought in by the founders as well as Intellectual Property brought in. Therefore, it is very important to set out as to what happens to the Intellectual Property that was brought in by the co-founders or was created during the course of business if he or she decides to quit the business. Therefore, to tackle this situation, the Intellectual Property Rights could either be assigned to the Company for a hefty amount, stake, etc. or could be licensed to the company on a royalty basis.download-2

Strong Dispute Resolution Mechanism: Even the above-mentioned clauses are taken care of with a strong Memorandum of Association in the backing; there are still chances of a Co-Founder dispute being raised. Therefore, there needs to be a strong and clear, predetermined mechanism for such dispute resolution which can resolve the issue quickly without causing any damage. For example, co-founders can decide to opt for mediation with a predetermined mediator to resolve any disagreement. Straight away taking the litigation path may hamper the company’s image thereby leading to losses. In the case of Housing.com, there was clearly no dispute resolution mechanism present, if any, therefore when the dispute escalated, the Co-Founder was left with no choice but to quit, twice. Mere difference in ideology, which can easily be resolved through mediation, witnessed 9 out of 12 co-founders exiting the company.