A co-founders’ agreement is a legal document that describes each founder’s roles, duties, and responsibilities, that helps in resolving potential disputes that might arise in the future. It is usually produced in the early phases of a company’s establishment, when the founders are laying the foundation for their enterprise.
In his book, ‘The Founder’s Dilemma’, Harvard Business School professor Noam Wasserman states that 65% (Sixty Five Percentage) of the startups fail due to conflict amongst the co-founders. At the onset of any venture, the founders generally commence with a common vision and shared optimism. However, as the venture grows, conflicts and deadlocks sprout due to varied reasons such as operational challenges, differences in decisions or the complex psychology of the humans.
From Sandy Lerner being ousted from Cisco, to Steve Jobs exit from Apple Inc., each instance highlights how crucial it is for co-founders to have explicit agreements from the beginning. It not only creates the foundation for setting out the ownership structure but also helps in the decision-making procedures of the company. It helps to avoid and resolve disputes and deadlocks by laying out precise rules for management and dispute resolution. The demarcation of duties, responsibilities, and business operations is outlined in this legal agreement amongst the co-founders. Co-founders must incorporate procedures for rejecting choices and saying no to maintain a positive working relationship. This entails outlining individual roles, creating veto power, and dividing up decision-making authority. The agreement reduces the possibility of disagreements, miscommunications, and power struggles and increases open communication and teamwork among co-founders.
Key Considerations in a Co-Founders’ Agreement
1. Roles and responsibilities
The roles and obligations of each of the co-founders of a venture should be well defined and demarcated in the agreement. The co-founders’ roles and responsibilities can be broadly categorized as follows: operations, marketing, technology development, sales, finance, and administration. Under this clause, each co-founder’s obligations, degrees of authority, and areas of specialty within the business can be outlined. It facilitates the development of a mutually understood agreement among co-founders on their respective roles, duties, and expectations of one another. This further ensures accountability of each of the co-founders towards their respective functions, and help in smooth operations of the venture.
2. Equity and ownership distribution
The term “equity ownership” describes the ownership stake in a business, which is commonly represented by shares. This covers the initial allocation of stock as well as any subsequent distributions contingent upon contributions or accomplished milestones. The determination of each co-founder’s equity ownership in the company is based on several variables, including financial investment, expertise, pre-existing intellectual property, industry network, and know-how. Depending on how many shares they own in a company, they are entitled to various benefits, such as percentage of its earnings and assets, ability to vote on corporate decisions, and the possibility of receiving dividends if the company decides to pay out its profits.
3. Vesting
The Founders’ Agreement contains a vesting mechanism that specifies how each founder’s shares will vest, acting as insurance if a co-founder quits or is ousted. There are two common techniques: (i) Time-Based Vesting: The founder’s shares will vest according to how long they worked for the company. If the founder chooses to leave the company before the end of his tenure, the remainder of his shares will be given back to the company. The agreement will specify a period, such as six months or a year, after which the vesting of shares will start (Cliff Period). This method tends to overlook the founder’s performance. (ii) Milestones Vesting: The agreement specifies milestones that must be met for shares to vest, with a focus on founder’s performance. The shares allotted to a founder who leaves the company before a milestone is reached are returned to the company.
4. Intellectual property ownership
This addresses matters about the ownership of intellectual property (IP), ensuring that any innovations, inventions, and creations developed by individuals within a company during or before their tenure becomes the company’s property rather than the individual’s. It’s typical for founders to own patents, trademarks, and other intellectual property at first, but these should eventually be transferred to their company in the event such intellectual property is used for the operations or development of the company. Intellectual properties have direct implication on the company’s valuation, and thereby, it is imperative to ensure that the intellectual properties are rightly held/owned by the company. Joint IP ownership between the founders and the business may be considered in specialized industries under certain circumstances.
5. Future financing
The co-founders’ agreement should specify exactly how each of the founders will provide additional funding to help the company expand. This means specifying whether the funding will come from debt or equity, and the timeline within which such additional financing shall be made. It should describe the interest rate that the company must pay on debt and the method of valuation for equity.
6. Management and decision-making rights
This section outlines the roles and responsibilities of each co-founder, including who will be responsible for making key business decisions. How basic and significant decisions are exercised has to be stated in the agreement. In addition, the composition of the company’s board of directors shall be set out. The process that the business must follow in the case of a deadlock in decision-making must also be specified in the agreement.
7. Transfer Restrictions
It is important to include in the agreement the rights and limitations of the founder and their capacity to transfer the company’s shares. This contains a method for a co-founder who wishes to leave before his term ends, as well as a lock-in clause that specifies a timeframe during which co-founders cannot transfer their shares. It is also necessary to specify how shares will be valued as well as the anti-dilution rights attached to them. A right of first refusal may be granted to the co-founders to keep outsiders from acquiring large stakes in the venture. In the matter of Kirloskar Ebara Pumps Limited and Ors. v. Riverdale Infrastructures Private Limited.[1], it was maintained that the law restricting the transfer of shares applies whether the company is public or private. Although the general principle allows shares of a public company to be freely transferable, there is no legal barrier preventing shareholders from agreeing to pre-emption clauses such as the right of first refusal.
8. Employment
It is usually assumed in a co-founder agreement that co-founders work full-time for the company. Every co-founder’s designation and the specifics of their employment, including compensation, benefits, and reimbursement policies, must be included in the co-founder agreement. A separate employment contract should be drafted to clarify specific employment terms and perks for each co-founder. The right of the founders to attest the company’s legal papers, such as contracts, cheques, etc., must also be included in the clause. Furthermore, clarity on the ESOP pool and the consequent and proportionate dilution of co-founders should be included in the co-founders’ agreement.
9. Non-compete
The non-compete clause is a crucial part of the agreement because it (i) guarantees that founders will commit all of their working hours to their role in the company and not take on other business ventures; (ii) prohibits the co-founder who has resigned from the company from approaching any of the company’s clients; and (iii) forbids founders from working in any capacity in a competing business for a term that should be explicitly defined in the agreement after they leave the company. There has to be a clear definition of what constitutes “conflicting disputes.” Any agreement that prevents someone from engaging in a legitimate trade, company, or profession is void[2]. Indian courts have taken steps to ensure that these agreements do not adversely affect workers once their employment ends, as these agreements are sometimes necessary from a business standpoint. The court held in Gujarat Bottling Company Ltd. v. Coca-Cola Co.[3], that non-compete clauses in franchise agreements are often essential for the efficient distribution of goods. Since these clauses serve the lawful goal of ensuring efficient distribution, they are not regarded as acts that restrict trade.
10. Confidentiality
It is essential for safeguarding private data, maintaining an edge over competitors, and ensuring legal compliance. Due to their close relationship with the company, the founders are privy to a great deal of private information, some of which may qualify as trade secrets. Contractually, the founders should not be allowed to reveal any private information that they have learned while working for the company, as this could seriously damage the company’s operations and valuation.
11. Jurisdiction, Law, and Dispute Resolution
The co-founders’ agreement must establish the applicable legislation and jurisdiction for resolving disputes. Indian law usually takes precedence unless there are foreign components. Depending on what the parties agree upon, jurisdiction may be either exclusive or non-exclusive. Furthermore, a well-defined process for resolving disputes is required; to prevent expensive and time-consuming court battles, alternative approaches like conciliation, arbitration, or mediation are frequently preferred, provided it is specified in the clause.
12. Termination and Exit Strategies
The agreement should specify the co-founder’s and the company’s rights to terminate it. The agreement may be terminated by either party with or without cause upon the occurrence of a certain event, or by the parties mutual consent. The conditions under which a founder may leave the company, and be released from their obligations should be agreed upon. The agreement may contain clauses such as buyouts or rights of first refusal that specify how shares will be handled if a co-founder decides to sell them. The agreement may also include exit plans that serve to safeguard the interests of all parties involved.
Conclusion
A well-crafted co-founder agreement is crucial for a company’s success as it minimizes conflicts, encourages teamwork, and protects the interests of everyone involved. By addressing key issues upfront and facilitating clear communication among co-founders, the agreement allows founders to focus on growing their business. Moreover, it demonstrates to potential investors that the company has a solid management framework, instilling confidence and attracting investment.
[1] MANU/NC/6830/2020.
[2] Section 27 of the Indian Contract Act of 1872.
[3] 1995 (5) SCC 545.