In this article, we’ll explain why a founder’s agreement is important and address the three main aspects that should always be included in your agreement: the assigning of the IP, the allocation of shares and the defining of each founders role in the company.

 

What is a founder’s agreement and why is it so important?

Most people start their new venture with a business partner, close friend or family member and usually focus on the business side of things, leaving the legal aspects for later. As for their partnership, people usually feel that it doesn’t require any legal validation (like through a founder’s agreement) Intellectual Propertyand that their close and trusting relationship is enough. In some cases, this might be true, but in most, it isn’t. Based on past research, 60%-65% percent of the start-ups fail due to conflicts between co-founders. This is an extremely high number, especially seeing how some fairly simple tactics can help prevent this. The two most obvious ones are knowing how to select the right partner, and signing a founder’s agreement.

So, what is a founders agreement? It’s a legally binding document, signed by the founders of the company, or a venture (even before establishing a company) which determines the founder’s rights and obligations towards the company (or venture) and each other. The agreement covers various legal aspects such as the purpose of the company, roles of each of the founders, working commitments, allocation of equity (shares), re-purchase rights in case a founder leaves and more.

The essential aspects that need to be covered

A Founders agreement is usually a long (9-15 pages) and complicated legal document, so despite their importance, we won’t be able to explain all the issues that need to be included. For now, we will focus on the 3 most important issues that need to be addressed in your founder’s agreement.

Assigning the Intellectual Property (IP)

As founder’s, you’re all bringing something to the table. One of you is doing the programming, the other is working on the business plan, and the third is doing the marketing. All of these are forms of intellectual property (“IP”) – and IP is what brings value to the company. At the end of the day, someone is going to buy you out not only because of you pretty blue eyes, but because they want your IP – whether it be computer code or a patent for some new product. When this happens, the first thing they’ll be checking in their due diligence test is: who does this IP belong to? And if this isn’t clearly defined in the founder’s agreement, it will be defined by the law in your country or by the courts if the situation is unclear.

Therefore, in order to remove all doubt, this issue should be addressed in the founder’s agreement. What you need to have is a provision assigning all of the IP relating to the venture, whether created before or after the signing of the founder’s agreement, to the company (or the future company to be incorporated). By transferring the IP to the company, you’ll be making sure that the IP is protected and owned by the company. Thus for example, if one of the founder leaves (say the one who did the programming), he won’t be taking the IP with him – something that would probably render the company worthless, or in best case, cause a long and expenses legal proceeding in court.

Allocation of Equity and Vesting – buybacks of Shares

Allocation of shares: The founder’s agreement must clearly state the percentage of shares given to each founder, and also the exact number of shares. For example: “David, CEO, will receive 25% of the shares, equal to 250,000 shares” (assuming the total amount of shares is 1,000,000). In most countries, the amount of initial shares is of no significance and you can decide to have 100, 1,000 or 1,000,000 – but you need to take in to account 2 things: the first is that you should use a number that’s easy to divide, so that down the road, you won’t have to have fractions. Second, there is a psychological affect – offering someone 20 shares (20%) (if you chose 100 shares) sounds a lot less attractive compared to offering someone 200,000 shares (if you chose the 1 million share option).

Vesting and buy-backs: one of the most important issues that need to be covered in the founder’s agreement is the vesting period, or even better, the buy-back mechanism. But let’s first explain what vesting is? Let’s say that David, John and Steven are partners in a venture, and they decided to divide the shares equally – 33.3% each. The question then becomes when would each founder receive these shares? There are 3 options (from the least best to the best):

The first, and less preferred method is that each founder gets all of his shares (33%) from day one. The reason that this is less preferred is because you need to ask yourself what would happen if after just one month, one of founders decides to leave? Is he still entitled to his 33% even though he only worked for a month? The two other founders would hope not, but if this is not clearly stated, he might be, which would then leave the company with only 66% of the shares – a situation which would make it almost impossible to get an investment.

non-competitionThe second option is to decide on a vesting schedule. This means that each founder is entitled to the same amount of shares agreed (33%), but that instead of getting the shares upfront, a portion of the shares will be allocated every x months. With this option, there will usually be an initial allocation of shares for each founder – this is often around 5%-10% – depending on how much work each founder has already contributed before the signing of the agreement. The most common vesting period is 3 years – the reason being that start-ups usually make it or break it during this time. The 3 year period is divided in to quarters. Example: each founder would get 5% when signing the founder’s agreement, and then every 3 months (remember: quarterly allocation periods) they would get another 2.33% [33% – 5% (initial allocation) and then divided by 12 quarters (4 quarters each year)]. The two main advantages of this method are: (1) it incentivizes the founders to stay in the venture and (2) if a founder leaves after a month, or 3 months, they only leave with a relative amount of shares, based on the amount of time they invested in the venture – unlike with the first option, where the departure of a founder could potentially cripple the venture.

The disadvantage of this option is that in some countries, the allocation of shares every few months, when in connection with the work put it, may be considered as a ‘tax event’ – meaning that the founders would have to pay tax every time they receive the shares (in our example, every quarter). Due to this reason, the third option is the preferred one.

The third option is a combination of option 1 and 2. The founders receive all the shares up front, but there is a ‘buy-back’ provision which, in simple terms, says: all the founders get their shares upfront (33%), but if a founder leaves before the 3 year period ends, the company can buy back the shares that have not yet vested (not yet been allocated to the departing founder). The calculation of the vested and unvested shares  is done based on the same vesting schedule mentioned in option 2 – a 3 year quarterly period and the buy-back fee is something symbolic – for example, 1$.

Example: the founders sign the agreement, they all get their 33%, but after 1 year David decides to leave. It isn’t fair for him to receive the whole 33%, but also for him not to receive anything seeing how he did invest 1 year worth’s of his time. Therefore, under this option, David will leave with approximately 14.5% of the shares [5% (initial allocation) + 9.3% (28%/12 quarters) x 4] and the rest of the shares (18.5%) would be sold back to the company for 1$.

Not managing the company’s shares correctly can be detrimental and therefore crucial that these issues be clearly defined and organized from the outset.

Roles and Working Obligations

In order to prevent misunderstandings and a sense of unfairness, it is strongly recommended to clearly define each founder’s role, what his or her responsibilities include (or don’t include) and how many hours a month they are expected to put in (before/after the initial investment).

This issue is particularly important in start-ups due to the fact that there may be long periods of time during which the founders don’t have an income from the venture and therefore work at other places and because the roles can often be confused seeing how all of the founders are involved in everything.

Solving this issue is fairly straightforward and only requires that each founder has a stated position (CEO, CMO etc), each role includes a list of responsibilities and each founder commits to a minimum amount of monthly hours. The provision should also say that if a founder does not fulfil his minimum responsibilities, the other founders may ask him to leave.

By assigning specific roles, you are creating a more organized environment in which not every minor decision requires a collective vote.

Additional provisions

Another 3 provisions which are important, include (1) a non-compete & confidentiality clause which helps prevent departing founders from using their knowledge to compete against the company; (2) a termination clause which clearly defines when a founder can leave and/or be dismissed which helps prevent internal quarrels on such a sensitive issue, and (3) the transfer of shares to others – or more accurately, when, if at all, can a founder transfer his or her shares to another.

Conclusion

Although a founder’s agreement is an optional legal document, that will usually be replaced by a more comprehensive document when the first major investment is made, it is one of the more important documents for the success of a startup. And yet, so many start-ups don’t have one. Our advice is this: once you know that you’re serious about the venture, try create a founders agreement and make sure the above issues are included.

The information presented is not legal advice, is not to be acted on as such, may not be current and is subject to change without notice.