In the excitement of launching a startup, many founders overlook a crucial element- the founder’s agreement. This document is not just a legal paperwork; it is the foundation that defines roles, responsibilities, equity ownership, and the roadmap for navigating challenges ahead. Structuring co-founders’ relationship is a process which cannot be forced-fit, particularly in case for the founders who have no prior track record of working together. Even in case of the founders who had known from early days, their previous relations may have not tested their equations during tough times.
Formalising founders’ relations involve candid discussions on a range of issues that eventually impact their long-term journey together. Founders are required to do hard talks, play leadership roles, take difficult decisions, be responsible for deliverables, performance assessment and so on. Unless this is done upfront, there are good chances of the team falling apart. Differences arise during the times when the roadmap laid down for their venture does not work, or deliverables of some of the founders are not on par with others founders, or there are long stretches of low phases. It is during such times the founders would need to engage in uncomfortable discussions on issues such as readjustment of roles and ownership.
Founder agreement:
Founder’s agreement is not a statutory agreement. But it is the first agreement recommended to be put in place even before the company is formed. It is an understanding and contract which governs founders’ business relationships, company ownership, outlines the rights, responsibilities, liabilities, obligations, and expectations from the startup. A Co-founder agreement is designed to protect each founder’s interests and documents that all founders are in alignment with the venture’s basic structure and how the founders will work together to move their business forward.
A Founder’s agreement acts as a guiding framework to avoid misunderstandings and resolve conflicts, ensuring a strong foundation for the business. For long term sustainability of co-founders relations and continuity of a venture, founders’ agreement ideally needs to be put in place before a company is incorporated. Forging an agreement between all founders helps mitigate the risk of a lawsuit over potential future disagreements. Further, as a company progresses and new investors become part of the company, this agreement becomes increasingly comprehensive and obligatory for founders. An initial founders’ agreement covers at least the following aspects, though the details could vary from case to case:
a. Business objective and long-term goal of the company. This may include core objective of the venture, strategy, direction, work culture and values, and so on.
b. Ownership of the intellectual property (IP), idea, technology, intellectual property, product, solutions, or any other asset based on which the company to be started, to be vested with the company. This would also include any pre-existing IP.
c. Equity ownership structure between the founders. Equity distribution between the founders reflects the capital contribution, risk-taking ability for starting a venture together, contribution of time, commitment, role and responsibility, financial contribution, and execution responsibility. The clause typically includes equity distribution, locking/ vesting period/cliff, future dilution, transfer of promoters’ equity, early exit of founders or entry of new founders at a later date, future ESOP, and so on. Here extreme situations such as founder’s death or physical incapacity also get covered. Some aspects about the decision to equity distribution between the founders is explained below.
d. Roles and Responsibilities of founders. This clause covers roles, responsibility, rights, obligation, contribution of the founders. Clearly defined roles and responsibilities prevent confusion, conflict, and establish accountability for performance. The process of making key decisions may also be covered either under this clause or in a separate clause.
e. Commercial terms for founders beyond equity ownership.
f. Confidentiality and non-disclosure by founders to ensure that the business information remains confidential and is shared only on need basis.
g. Indemnification for representations and warranty of facts and promise to protect another party if they suffer losses resulting from the falsehood of another party’s representation.
h. Disclosure of conflicts of interests, IP ownership, other business interests of founders.
i. Exit mechanism of a founder covering various scenarios and eventual restructuring of equity ownership.
j. Non-compete and non-solicit provisions for founders during and after certain period of their serving the company in a role that could compete with the company.
k. Dispute mechanism and deadlock provisions to cover the method through which major disagreements and disputes between the founders can be resolved. It may also include external intervention in case of deadlock situation.
l. Jurisdiction is a choice of law provision which the founders specify or stipulate that any dispute or lawsuit that arises out of the contract between them will be determined according to the law of a particular jurisdiction.
m. Winding up and dissolution provisions enlisting the process for winding up of the company
Differences between founders could lead companies to fold their operations. A well-drafted founder’s agreement prevents such closure, and helps in smooth parting of founders saving the companies. Aman Goel, a serial entrepreneur shared his experience about the first startup that he co-founded with his friend and classmate with equal (50%) equity holding by each founder. Within a year, his co-founder had decided to quit. Because of the founders’ agreement, Aman and his co-founder parted ways amicably, with entire equity of the exiting founder getting transferred in Aman’s favour. The agreement saved the company, which went on to become successful and was acquired by a larger company.
Equity ownership
Equity distribution reflects the ownership of startups between its co-founders. When co-founders come together to start a venture, typically they split founders’ equity equally. Equal distribution of the founders’ equity also means that all the founders take the same risk of starting a venture together, contributing equal in terms of time, commitment, role and responsibility, financial contribution, and execution responsibility. Aspects such as founders’ ability to execute ideas into venture, ability to reduce certain risks from a company because of their competence, their past contribution, future commitment with regards to time, roles and responsibilities, their additional contribution in the company whether in cash or in kind, are determining factors for initial capital structure. In a blog written earlier, the followings were listed as key factors that would influence the allocation of founders’ equity:
a. Founders’ commitment and ability to take risk
Under this factor, the time commitment (full time vs. part time) and timing of joining the venture (from the beginning or after achieving a significant milestone) would influence the distribution of equity among founders.
b. Founders’ ability to lessen risk
The initial equity distribution should be in proportion to the founders’ ability to reduce critical risk and assume responsibility in minimising technology, product, commercial and financial failure risk of the company. One yardstick to assess the criticality of risk factors is that if a founder handling a particular function left, would it severely impact the company’s existence or the its chance for fund raising.
c. Founder’s contribution in cash or kind
Equity further needs to be adjusted for founders’ additional contribution such as pre-existing Intellectual Property or higher capital investment or in-kind contribution such providing cost-free infrastructure, buying equipment or software for the company or contribution by virtue of which the startup would gain commercial or competitive advantage.
d. Other aspects
Aspects such as payment of market salary to some of the founders or more experience say, one of the founders being a serial entrepreneur, enhance chances of getting investment, and influence the equity distribution between founders. At times, equity is also adjusted for some significant milestones achieved because of a particular founder. In addition, equity may require to be reallocated if a founder leaves the startup early, or when a new founder is brought onboard later to address critical gaps within the company.
It may be noted that the founder’s equity gets unlocked as per vesting provisions. Typical vesting periods stretch to 4-5 years. Vesting of equity over a period of time would save the company in case of disagreement between the founders leading of parting of a founder from a company.