Author’s Note
The movie “Facebook” mostly revolves around a bitter and long lawsuit between founders Mark Zuckerburg and Eduardo Saverin which led a lot of people thinking about the legal requirements around a startup.
Most startups around India and even the world are started between friends, roommates and such.
These relationships come with an inherent trust but going ahead with business operations disagreements are bound to happen. This is where co-founders agreements come in picture.
Stop worrying about your co-founders, let the agreement take care of it and focus on your startup.
Table of Contents
- Approach towards understanding the need for a Co-founders Agreement
- The Right Time to sign a co-founders agreement
- Important Clauses to a Co-founder’s agreement
- Ownership
- Vesting
- Roles and Responsibilities
- Intellectual Property (IP)
- Confidentiality
- Dispute Resolution
- Representations and Warranties
- Choice of Law
- Step-By-Step (Questions to Ask)
- Strategy
- Ownership Structure
- Management
- Conclusion
Approach towards understanding the need for a Co-founders Agreement
Most startup owners that I’ve interacted with or worked with are rather hesitant to make a co-founders agreement and feel as though it’s unnecessary at best and a complete waste of time at worst. This is usually rooted in the relationship that the founders already share, in the lion’s share of startups the founders are either friends, family or hold a prior close association this leads to a sense of security against any ensuing misgivings.
However, it is important to understand that an agreement of this nature is in no form meant to cast doubt upon the working of the founders together but is, in fact, a testament to the vision all founders share to protect the interests of the business going ahead. Think of a co-founders agreement like a constitution for the working of your business just like a country’s constitution oversees the powers of the government.
Another major benefit of making such an agreement is that while deliberating upon the terms a commonality noticed is there is renewed clarity about the aims, roles, and visions involved in the growth of the business, it may so happen that a founder may discover that they simply don’t share the same goal as that of their co-founder and break their association then instead of in the future when it might be too late.
The Right Time to sign a co-founders agreement
Your business and dreams are running at the speed of light and you want nothing to stop this meteoric growth. However, a co-founders agreement is not a stoppage but rather an additional lifeline for the rocky roads ahead.
To be honest, there’s no perfect time to sign a co-founders agreement but the general rule of thumb is “the sooner the better” due to the dynamic nature of startups it’s advisable to sign one at the earliest.
Important Clauses to a Co-founders agreement
Ownership
A clause most common in co-founders agreements is determining the ownership structure of the startup. This usually includes the portion (or number) of shares held by each founder in the business. The number of shares owned by the partners is based upon a number of things ranging from the initial capital investment to the partner’s involvement in the startup. To wrap up this section, it remains crucial to be clear and transparent about the ownership structure in order to avoid any future conflicts.
Vesting
Continuing on the theme of ownership structures, vesting helps to deal with a situation where one of the co-founders has been removed or has left the company. Vesting essentially is more like earning the ownership shares in the startup so essential over a given period and/or operations the founders earn their shares.
I understand that this might be a bit confusing but bear with me, it gets better . I strongly believe that looking at different vesting used along with illustrations for the same will make things significantly better.
Usually, there are three main types of vesting schedules used in agreements :
Time-Based – As the name already explains, in such a structure the founders gain ownership shares over time. These time periods are pre-decided and often some with a cliff of a year or two. A cliff is the first portion of time before the ownership grants come into force.
For example, in a time based on a one year cliff; the vesting options come into play when the person has been with the startup for at least a year and following which supplemental shares are granted with the passing of fixed periods.
Milestone Based – Another scheme which is quite clear by the name itself, vesting options are available after the completion of a particular goal or a special project. Oftentimes in the case of startups milestones are set for certain valuations or perhaps sales depending upon the nature of the startup.
Hybrid Vesting – It is a combination of the above two approaches where the person must stay with the company for a certain period as well as there must be the completion of one or more of the goals laid down.
Roles and Responsibilities
Oftentimes all co-founders belong to the same field which leads to an overlap of roles in the business which leads to nothing but chaos. Therefore it becomes abundantly crucial to assign roles and responsibilities to each of the founders in accordance with their expertise and skills. This not only helps in clearing the air but also leads to greater efficiency and as commonly seen helps startups put their limited resources to proper use.
Intellectual Property (IP)
There are certain types of intellectual properties that we should discuss here such as patents, trademarks, copyrights, etc. Intellectual property is something that is invested initially by the founder to build or start-up their business. And this intellectual property is assigned to the start-up owned severally by the co-founders. It means this protects the IPR and trade secrets of the business in case the founder wishes to leave the organization in the future.
The provision ensures that any Trademark, Copyright or Patent obtained by a founder during the course of their association with the start-up are the property of the start-up for all purposes. This clause plays an essential role in start-up valuation as any Intellectual Property owned by the business increases its value.
Confidentiality
Confidentiality in layman’s terms means keeping secret, a confidentiality clause in the agreement makes sure that each person that signed it promises to keep the important information and communication related to the organization concealed.
As a legal term, confidentiality refers to the duty of an individual to refrain from sharing confidential information with others, except with the express consent of the other party. It means no co-founders individually can use the business information, sell or share any business information or sensitive information to the third party, after leaving the organization. co-founders may disclose the business concept only on an as-needed basis and only upon agreement of all co-founders. It means there must be a consent of each and every co-founder. This clause prevents any form of data theft by a co-founder and provides a remedy in case an existing co-founder steals sensitive company information or client data.
Dispute Resolution
Dispute resolution refers to those provisions in the co-founder’s agreement that can lay down mechanisms to resolve the dispute between two or more co-founders. Such provisions usually include the remedy that can be availed in case of violation of the co-founders agreement by any of the co-founder.
The provision must mention the laws applicable over such disputes as well as the jurisdiction of the court to take up the matters legally.
For example, the clause may lay down arbitration as the means of resolving the dispute. In a nutshell, arbitration is the settling of the dispute outside of courts by awarding arbitral awards that are legally binding upon both parties. Another example can be that the clause may specify which court may be approached first, so in the case of a startup based in New Delhi, the clause should specify a court in Delhi’s jurisdiction as per their location.
You can have two or more dispute mechanisms in the same agreement. For example, a dispute regarding the technical aspects of your business can be referred to arbitration and a dispute regarding the shareholding can be referred to courts.
Representations and Warranties
A representation and warranties clause is specifically crucial to those founders that do not possess a prior close association. In such a clause, representation would be anything one of the founders asserts to be true which leads to a contract being formed. A warranty is the promise of indemnity in case the representation made by one of the partners was false.
For Example – If A represents and warrants to B that the C is major (which in reality is false) and you can contract with him. A would-be liable for the damages of B suffered due to the false statement of A.
Choice of Law
A Choice of Law provision is a provision in which the parties coming from different jurisdictions come together to form a startup to decide upon which jurisdiction of laws shall apply in the case of a dispute between the founders. This is to ensure that there is no confusion with regard to which courts to approach in the case of a dispute between said founders.
Step-By-Step (Questions to Ask)
Before starting the process to make the agreement it’s important that the founders evaluate their business and the direction they envision for the business.
This would involve the founders asking the tough questions so to say. Understandably many of the questions would venture into subjects not previously decided or touched upon. However, it’s paramount that at such a crucial juncture all these issues are addressed. As broadly as possible I have framed a set of questions applicable to enterprises from all industries divided into following units; Strategy, Ownership, and Management.
Strategy
- What are the prospective aims and goals that each of the founders wants to underline for the business?
- What goals do the individual founders have for themselves?
- In how much time do you see our business achieving these goals? – setting timelines
Ownership Structure
- How do we allow the percentages of the business?
- How and what will we each contribute to the business? (e.g., duties, job descriptions, hour commitments, roles, and responsibilities).
- How much capital are we each contributing and for what? – This capital may be in cash, kind, goodwill, expertise, etc.
- Will the ownership shares (percentage of) be subject to vesting based on continued participation in the business?
Management
- How will we undertake day-to-day decisions regarding the working of the business? – majority votes or department-specific or discretion of the CEO.
- What remunerations (if any) are the owners entitled to? How and if that can be amended?
- Detailed step-by-step if one of the partners decides to leave
- In case one of the partner leaves, does the other partner have the right to buy to have interest in the other partner? If yes, at what price?
- Can one of us on our own sell the business, raise money or close down the business?
- What will be the contingency in the unfortunate event where one of us passes away or becomes incapacitated?
- How will we remedy a situation where our product takes longer than expected to be ready?
- Is it permissible to any of the founders to launch another startup while working upon this project?
- What circumstances must prevail to remove a founder as an employee of the business?
- How will we deal with a situation in which one of the partners is not living up to the requirements of the founder’s agreement? What possible remedies do we exercise in such a case?
- In the unfortunate situation where this venture does not take off and we collectively decide to shut down operations, can one of the founders try it again anytime in the future?
- In a situation we need to raise more capital, how and where will we raise said capital from? What percentage of the business are we willing to liquidate?
Conclusion
Despite the startup sphere taking giant strides each day, they often turn a blind eye towards legal requirements which in the long term have serious repercussions.
Thus, despite already having the busiest schedule going around, startup founders need to carve out time to make such an agreement not just to protect their business but even to understand the compatibility of the visions all the founders and goals each of them are trying to achieve both for the business and personally as well.
