Founders Agreement: Ultimate Practical Review Guide

This guide provides a straightforward and concise overview of the key elements in reviewing a Founder's Agreement. Aimed at helping entrepreneurs and founders understand and navigate the essential aspects of this crucial document, it covers ownership, roles, financials, and dispute resolution, ensuring a solid foundation for any business venture.

What is a founders agreement

A Founder's Agreement is a crucial document in the world of entrepreneurship. It serves as a formal written understanding among founders of a new venture, delineating their roles, responsibilities, and share in the business. Though not legally mandated, its practical significance in the successful operation and management of a business cannot be overstated.

Entrepreneurial ventures, often initiated between friends or family, are prone to relational strains under business pressures. Such strains can lead to breakdowns in communication and cooperation, ultimately affecting the business. A Founder's Agreement can mitigate these risks by providing a clear framework for addressing and resolving potential disputes. It is a strategic tool that ensures clarity, alignment, and protection for all parties involved in a venture. By addressing key issues such as equity distribution, roles and responsibilities, dispute resolution, and share transfer restrictions, this agreement lays a solid foundation for the successful growth and management of the business. Therefore, reviewing and establishing a well-drafted Founder's Agreement should be a priority for any entrepreneurial team.

Why a Founder's Agreement is Necessary

1. Protection of Interests

Founders bring unique assets and skills to a venture. A Founder's Agreement ensures that each founder’s contribution is recognized and protected. This document details the ownership structure, roles of each founder, and the process for dispute resolution. In scenarios of disagreements or founder exits, the agreement provides a pre-defined resolution pathway, safeguarding individual interests.

2. Clarity of Vision and Roles

Start-ups often face challenges due to misaligned objectives and unclear roles. The agreement sets out the company's goals, objectives, and the specific responsibilities of each founder, ensuring that all parties are aligned and committed to the company’s vision.

3. Prevention of Legal Disputes

In the absence of a Founder's Agreement, disagreements can escalate to legal disputes, leading to costly and time-consuming court proceedings. The agreement specifies how disputes should be resolved, thereby avoiding potential legal entanglements.

4. Management of Founder Exits

The agreement outlines various scenarios in case a founder decides to leave the venture. It details the implications for their shares, intellectual property rights, and technical knowledge. This clarity is vital for both voluntary and involuntary exits, ensuring the company's stability and continuity.

5. Control of Share Transfers

One critical aspect of the agreement is the limitation on the transfer of shares. It can incorporate a ‘right of first refusal’ clause, as seen in Section 142(1) of the Companies and Allied Matters Act (CAMA) 2022. This clause ensures that founders can only transfer their shares to external parties after offering them to existing shareholders, thereby maintaining control within the founding team.

Full Checklist for Reviewing a Founders Agreement

1. Ownership Structure

  • Assess Equity Fairness: Determine if the equity distribution fairly represents each founder's contribution.
    • Consider: The balance between monetary investment, expertise, and resources contributed.
    • Example: If Founder A’s large cash investment is undervalued compared to Founder B’s smaller time commitment, recommend a revision reflecting the monetary value.
  • Plan for Dynamic Equity Adjustments: Check for mechanisms to adjust equity based on evolving contributions.
    • Consider: Future scenarios where founders may contribute significantly more or less.
    • Example: If a future tech development by Founder C dramatically increases company value, ensure a clause exists for increasing their equity stake.
  • Evaluate Voting Rights and Minority Protections: Ensure alignment between equity shares and voting rights, and check for minority shareholder protections.
    • Consider: The potential for majority shareholders overpowering minority interests.
    • Example: If minority founders lack adequate protection, suggest including tag-along rights in the event of a majority share sale.

2. Equity and Vesting

  • Review Vesting Schedules for Appropriateness: Examine if the vesting period aligns with industry standards and incentivizes long-term commitment.
    • Consider: The balance between encouraging commitment and allowing flexibility.
    • Example: If the vesting schedule is too rapid, propose extending it to align with standard four-year periods with a one-year cliff.
  • Analyze Milestone-Based Vesting for Realism: Ensure that the milestones are achievable and reflective of meaningful company progress.
    • Consider: The company’s growth trajectory and the feasibility of set milestones.
    • Example: If milestones are set unrealistically high, recommend adjusting them to more attainable yet challenging targets.
  • Evaluate Terms for Early Exits: Assess whether the terms for early exits are fair and protect both the exiting founder and the company.
    • Consider: The impact of an early exit on both the founder and the company.
    • Example: If a founder’s exit terms are too punitive, suggest a more balanced approach, like a tiered buy-back based on time spent at the company.

3. Roles and Responsibilities

  • Evaluate Clarity in Role Definitions
    • Consider: Aligning duties with each founder's skill set to avoid overlap and ensure efficiency.
    • Example for Review: If both founders have similar skills, clearly delineate responsibilities to prevent conflicts, like who handles external communications versus internal management.
  • Assess Linkage of Performance Metrics to Roles
    • Consider: Setting consistent and clear performance metrics for each role.
    • Example for Review: If a founder’s role is sales-oriented, their performance metrics should be based on sales targets rather than product development milestones.
  • Examine Deadlock Resolution Mechanisms
    • Consider: Avoid requiring unanimous consent for all decisions and having clear deadlock provisions.
    • Example for Review: If the agreement requires unanimous decisions for operational matters, suggest a tiered decision-making process where some decisions can be made by a simple majority.

4. Transfer of Shares

  • Verify Lock-In Period Details
    • Consider: Establishing a clear and reasonable lock-in period to ensure stability while allowing flexibility.
    • Example for Review: If the lock-in period is too long, consider reducing it to a standard timeframe, like 1-2 years.
  • Review Provisions for Early Exit Scenarios
    • Consider: Having fair and practical buy-back clauses and avoiding punitive measures.
    • Example for Review: If a founder exits early, their shares could be offered to existing founders at a fair market rate rather than a discounted or inflated price.
  • Scrutinize Share Valuation Methodology
    • Consider: Using a transparent and agreed-upon formula for share valuation.
    • Example for Review: If the current method is ambiguous, propose a valuation based on the company's financial performance or an external valuation at the last funding round.
  • Ensure Right of First Refusal is Clearly Outlined
    • Consider: Clearly defining the process and timeline for exercising the right of first refusal to ensure fairness and transparency.
    • Example for Review: Specify a clear timeline for other founders to respond to a share sale offer, such as 30 days.

5. Intellectual Property Assignment

  • Confirm Assignment of IP at Incorporation
    • Consider: Ensuring all relevant IP is assigned to the company upon incorporation to secure company assets.
    • Example for Review: If a founder has developed a crucial technology, ensure it is legally transferred to the company.
  • Address Management of Future IP Creation
    • Consider: Clearly stating that IP developed during tenure belongs to the company.
    • Example for Review: Any software developed by a founder for the company should automatically become company property.
  • Evaluate Valuation Process for IP Transfers
    • Consider: Fairly valuing IP transfers to ensure founders are adequately compensated.
    • Example for Review: If a founder brings in existing patents, ensure their valuation is reflected in their equity share.
  • Review Protection Clauses for IP
    • Consider: Including strong confidentiality and non-compete clauses to protect the company's interests.
    • Example for Review: Implement clauses that prevent founders from using company IP for personal gain or in future ventures.

6. Expenses and Budget

  • Assess Financial Transparency
    • Consider: Ensuring complete transparency regarding the company's current financial status.
    • Example for Review: If there are pre-existing debts or liabilities, these should be clearly disclosed and considered in the budget planning.
  • Evaluate Documentation of Funding and Investments
    • Consider: Outlining in detail any seed investments or funding received, including the terms and conditions associated with them.
    • Example for Review: If the company received a $50,000 seed investment, specify the investor terms, such as equity stake or repayment obligations.
  • Analyze Operating Expenses Documentation
    • Consider: Explicitly documenting all current and projected operating expenses.
    • Example for Review: Break down expenses into categories such as salaries, marketing, R&D, and operational costs, ensuring all founders understand the spend and burn rate.

7. Salary Compensation

  • Establish Initial Compensation Details
    • Consider: Clearly outlining the initial salary or compensation for each founder, even if it is minimal or deferred.
    • Example for Review: If founders initially forgo a salary, document this decision and the conditions under which compensation will commence.
  • Plan for Compensation Growth
    • Consider: Creating a structured plan for compensation increases linked to business milestones or funding achievements.
    • Example for Review: Outline a plan where founder salaries increase by a certain percentage after reaching specific revenue targets or securing a new round of funding.
  • Ensure Transparency and Agreement on Compensation
    • Consider: Making sure all founders agree on the compensation structure and understand how it aligns with the company’s financial health.
    • Example for Review: Document a unanimous agreement on compensation terms, including any discrepancies in pay due to differing roles or contributions.

8. Dissolution and Termination Clauses

  • Outline Dissolution Procedures and Outcomes
    • Consider: Clearly defining the process and outcomes in the event of the company's dissolution.
    • Example for Review: In case of dissolution, establish how any remaining assets, profits, or intellectual property will be divided among founders or handled.
  • Agree on Asset and IP Distribution
    • Consider: Detailing how the company's assets, including patents and technologies, will be distributed or managed if the company is dissolved.
    • Example for Review: If the company owns patents, decide whether they will be sold and proceeds divided, or if ownership reverts to the inventing founder.
  • Establish Termination Clauses for Founder Exits
    • Consider: Documenting the implications of both voluntary and involuntary founder exits on their shares and intellectual contributions.
    • Example for Review: For a founder's voluntary exit, outline a process for share buyback or redistribution, and stipulate how their intellectual contributions will be retained or compensated.

9. Governing Law and Dispute Resolution: Making the Right Choice

  • Selecting the Appropriate Governing Law
    • Guidance: Prioritize the law of the state where the company is located as the governing law for the agreement. However, if founders are based in different states or countries, it may be advantageous to choose the legal system you are most familiar with.
    • Example for Consideration: If the company is based in New York but one founder is located in California, New York law is preferable. However, if all founders are more familiar with California law, consider opting for it to ease understanding and compliance.
  • Deciding on Dispute Resolution Method
    • Arbitration vs. Court Litigation:
      • Arbitration Advantages: Typically faster and more confidential than court proceedings, arbitration can be less adversarial, preserving business relationships.
      • Litigation Advantages: Offers a more formal resolution process, with the possibility of appeal and a more structured enforcement mechanism.
    • Guidance: Choose a dispute resolution method that aligns with your budget, familiarity, and enforcement needs. Consider the nature of potential disputes and where you need a quick, private resolution (favoring arbitration) or a more formal process (favoring litigation).
    • Example for Consideration: If cost and confidentiality are major concerns, arbitration might be the preferred method. For complex legal issues where precedent and appeal options are important, court litigation could be more appropriate.