Importance Of A Founder’s Agreement

Introduction

A Founder’s Agreement (“Agreement”), while not mandatory, is an essential element of a startup that is founded by more than one person. The customary entity for a startup in India is a private limited company.

Co-founders come together for a variety of reasons, which include bringing together each person’s unique skillsets, connections and network. Co-founders could be friends, family or just professional acquaintances who, together, see a vision that they would like to achieve with each other’s help and contributions.

Irrespective of the level of prior intimacy among the co-founders, it is always advisable to lay down in clear terms the working relationship between the parties, which would in turn ensure smooth and efficient function of the business. The terms and the draft of an Agreement are usually agreed to prior to incorporation of the company and this agreement is signed either simultaneously with the incorporation process or prior to the incorporation process, and the company is incorporated after its execution.

Matters to be covered

It is important that the Founder’s Agreement covers the following aspects:

1. Roles and responsibilities: As each founder brings their own skillset, experience and expertise to the table, it is important to set out the broad working relationship between the parties in terms of roles and responsibilities. Usually, designations are assigned for each co-founder and each co-founder is broadly responsible for their own division and the buck stops with them. Business divisions may include operations, technology, sales and marketing, finance, etc., and the founders may choose the title that will best describe their role.

2. Business strategy and long-term vision: The company’s goals would need to be clearly defined in a more specific manner than the business objects stated in the Memorandum of Association (“MOA”) of the company. This should ideally include both the short-term goals and long-term vision for the business. There may be a consensus on a broad business plan in the Agreement along with broadly defining certain milestones for the company, which may be in terms of revenue or targets and a more detailed version of the business plan (which includes these milestones) may be prepared subsequently and updated from time to time.

Where the founders join together with a goal and the strategy is yet to be evolved, then it would suffice if the goal were laid down.

3. Ownership structure: For a private limited company, ownership is defined by shares held in the company.

• Founder Shareholding: Depending on each founder’s role and contribution, shareholding percentage can be determined on initial subscription of shares via contribution to the initial paid-up capital of the company, and the same should be recorded in the agreement.

• ESOP pool: The founders can also decide on the extent of shareholding that they desire to be set aside for an employee stock option pool (“ESOP”). ESOP is used to incentivise future hires of the company, who may even be credited as a co-founder.

The detailed terms of the ESOP, including the eligibility criteria, vesting schedule and number of stock options, is covered under a separate scheme approved by the board and the shareholders of the company, which can be structed after the company is incorporated at an appropriate time.

4. Decision making arrangement:

• Board meetings: A private limited company needs to have a minimum of 2 directors on the board and a maximum of 15 directors (this number can be increased by way of a special resolution). Depending on the number of directors on the Board, the agreement should spell out the quorum required for each meeting of the Board and if required, some major decisions would need the presence and approval of all directors on the Board. Co-founders may also consider the presence of an independent director on the Board in a non-executive capacity who may be an industry expert or mentor/advisor, whose decisions and input would come in handy from time to time, especially in a deadlock resolution situation.

• Shareholder meetings: For shareholder meetings, each equity shareholder gets a vote and for these meetings as well, depending on the number of shareholders, a quorum should be spelt out in the agreement. It should be noted that, as per the Companies Act, 2013 (“Act”), certain specific decisions require approval of the shareholders by way of a special resolution including but not limited to amending the memorandum or articles of the company, increase in authorized share capital, reduction of share capital, buy-back of shares, certain borrowings, related party transactions, etc. A special resolution requires three times more votes cast in favour of that item of business in such shareholders meeting than votes against such item.

• Other business decisions: For other business decisions that do not require board or shareholder approval, especially decisions related to day-to-day operations, the power to make such decisions can lie with the founders and senior management depending on their designation and role in the business and what business division they are responsible for. Some of these decisions can be taken by the founder heading the relevant business division, while for some other decisions that are general in nature and pertain to the business as a whole (such as those related to administration, budgets, office-related, etc.), a committee may be set up consisting of the founders and certain senior management personnel to decide on these general matters.

5. Salary and compensation: Until the company reaches a certain level of revenue or is able to attract external investment, founders can expect to receive a minimal level of compensation. However, it may be prudent to set out a compensation plan setting baseline compensation and accounting for future growth of the company. In addition, the Agreement can spell out the expenses of the founders that are covered by the company as a business expense, which may also include some additional perks to overcome the minimal compensation in the initial phase of the startup. The Agreement should also cover the signatories of the bank accounts of the company and how differing amounts of expenditure require differing levels of sign-offs from the founders of the company.

6. Procedure for transfer of ownership:

• Lock-in period: Founders should agree on the mechanism for restriction on transfer of shares held by each of them. To begin with, there may be a lock-in period decided during which the founders are not permitted to transfer their shares in the company. Possible exception to transfer during the lock-in period could be transfer of a limited percentage of shareholding to relatives (as defined under the Act) and transfer with the prior written consent of all other founders.

• Right of First Refusal: Upon expiry of the lock-in period, in the event any of the founders wish to transfer a part or their entire shareholding in the company due to a voluntary exit (either full or partial), the other founders should have a right of first refusal whereby such transferred shares should be offered to the other founders first and only upon their refusal to purchase all or part of offered shares, can the transferring founder sell such shares to a third party.

7. Anti-dilution protection: In some cases, certain founders, especially a founder holding a significantly lower stake than others, may need to be protected from dilution of their shareholding percentage in the company. Anti-dilution protection arises in the event of future investment in the company by way of infusion of share capital that would result in a dilution of the stake of all founders. Founders holding a minority stake which is intended to be protected from dilution should ensure that a mechanism is in place in the Agreement that involves either further issuance of shares to such minority founders at the lowest possible price or transfer of shares by the other founders to such minority founders in order to help maintain their shareholding percentage in the company.

8. Protection of intellectual property of the business: For all the intellectual property created by the co-founders that are capable of being protected and registered under applicable law, it is imperative that the legal ownership of such intellectual property be vested in the name of the company and not in the name of any of the individual founders. In addition to the Agreement, the founders may also enter into employment agreements/ service contracts with the company and this IP protection should be detailed thereunder as well. Further, this protection should extend to all other employees, consultants and contractors of the company and this concept of ‘work made for hire’ should be enunciated clearly in their respective agreements with the company.

9. Non-compete: An important clause in the Agreement is the non-compete that (i) ensures that founders dedicate their entire working time towards their role in the company and not engage in other business activities, and (ii) precludes founders from engaging in a competing business (which should be a defined term in the Agreement) in any capacity whatsoever post their exit from the company for a certain limited period of time. This would also be covered in detail in the employment agreements/service contracts that founders may enter into with the company.

10. Indemnity for Directors: To the extent permitted by the Act and applicable law, indemnity may be provided to directors in the event of any loss that they may suffer as a result of their discharge of duties towards the business. Under the Act, there is no restriction on a company indemnifying its directors in this regard.

11. Removal of a founder: In the unfortunate events of death, disability, under performance, breach of law, sexual harassment, misappropriation of funds, etc., involving any of the founders, a mechanism should be detailed on the procedure for the exit/ removal of the founder. In the event of death or disability, there may a severance package provided to the founder or his/her legal heirs. More importantly, in these events and in all other circumstances involving the founder committing an act of moral turpitude, there should be a mechanism in place whereby the shareholding held by such founder is bought out either by the company or the other founders at the lowest possible discounted value.

12. Dispute resolution mechanism: The Agreement should set out a methodology of settling disputes among founders in relation to the terms of the Agreement and the business. In the event the founders are unable to settle disputes among themselves in an amicable manner, a mechanism may be introduced in the Agreement for appointment of an independent third party mediator to help settle the dispute. If this fails, arbitration is a preferred method of dispute resolution between the founders because of its benefits as compared to litigation.

All the terms of the Agreement must be incorporated into the Articles of Association (“AOA”) of the company either by way of amendment (if the company is already incorporated) or at the time of drafting the AOA of the company prior to incorporation. In addition to the terms of the Agreement, it is also recommended that the AOA grant the company the power and authority to issue shares on a preferential basis and to issue different types of instruments including the various types of preference shares, debentures, etc., in order to accommodate future investment in the company. The broad business objects of the company are set out in its MOA.

Conclusion

Co-founding a business can be compared to a marriage. Since founding a business is a serious, long-term commitment, it is important to have the roles and responsibilities and working arrangement clearly defined. When founders get together, they usually do not envision or discuss separation, but it happens in a lot of cases and it is better to be prepared for that eventuality. To ensure continuity of the business and at the same time, strengthen each founder’s commitment to the business, a Founder’s Agreement is a fundamental step in every entrepreneur’s journey.

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Contributing Advisors