Building a Strong Foundation vis-a-vis Founders Agreement

In this jet age and in the world of emerging start-up culture, understanding the need for and importance of a founders’ agreement becomes an absolute necessity to build a strong foundation for a start-up company. A founders’ agreement lays the pillar on which founders plan and work together, take critical business decisions, and share responsibilities, all while they embark on their entrepreneurial journey. A well-thought and well-drafted founder’s agreement helps prevent future disputes and serves as a safeguard for both - the company and its founders, while also making it an essential step in the business formation process.

Meaning of Founders Agreement

A founders’ agreement is a legally binding contract that defines the relation between a company and its founders. It is a crucial document that is signed by all the co-founders of a company, and it outlines the framework on the business of the company, equity ownership for each co-founder and the role and responsibilities that each co-founder will assume to run the business. The primary purpose of a founders’ agreement is to set out a well-defined structure for the founding team and ensuring that each founding member has mutual understanding of their obligations, responsibilities and liabilities towards the company.

Majorly there are two types of founders’ agreement: founders’ service agreement and founders’ collaboration agreement. A founders’ service agreement is an agreement between the company and its founders that lays down the terms and conditions of their employment status and services that they would offer to the company. On the other hand, a founders’ collaboration agreement is an engagement between the co-founders of a company as it defines the terms for the roles and responsibilities that will be shared among the co-founders to establish and run the business of the company. A founders’ collaboration agreement helps in preventing misunderstandings among the co-founders and ensures that their interests are aligned and the roles are bifurcated as per each co-founder’s expertise.

Need for Founders’ Agreement

The founders’ agreement works as an official guideline that governs the relationship among the founders and their roles and responsibilities towards the company. Since it primarily contains equity ownership, dispute resolution methods, intellectual property rights and structure of the company, it acts as an insurance mechanism against unexpected situations that may arise during the course of setting up of the company.

A founders’ agreement also plays a pivotal role in defining and protecting the equity owned by each co-founder. It further ensures that an appropriate compensation is provided to the founders. Define responsibility in such agreements include decision-making rights, voting rights and ownership rights, and these prevent confusion or conflicts among the founding team. A founders’ agreement additionally might include a vesting schedule which protects the company and other founders from any founding member exiting the company without fully contributing to the business of the company and overall it also encourages the founders to stay committed towards the company and business growth prospects.

Having a well-structured founders’ agreement in place, can help a company attract potential investors during the fundraising process through showcasing the detailed planning and management structure of the company. The absence of a founders’ agreement can come across as a warning sign for investors as it increases the risk for potential conflicts, fallouts and misunderstanding among the founding team indicating a poor governance.

Key Components of a Founders’ Agreement

A founders’ agreement is drafted according to the company’s specific needs and situation. However, certain crucial clauses must always be included in a founders’ agreement:

• Roles and responsibilities of each founder: For an efficient functioning of the business, each founder’s rights and responsibilities must be laid down in detail. If such roles and responsibilities are not well-defined in the agreement, the possibility of a chaos and confusion like situation among the founders leading to disputes and misunderstandings become high. Therefore, in order to avoid such situations, a clear demarcation of each founder’s role and responsibility is necessary.
• Equity Ownership: An equity clause is crucial to a founders’ agreement as it defines the equity ownership for each co-founder based on their contribution of capital in the company. It specifies extent of ownership of each founder. The equity distribution is usually determined by factors like financial investment, contribution in intellectual property, work experience, market connections or technical or business expertise of each founder. Additionally, voting rights of each founder are also defined and agreed basis their investment.
• Vesting Schedule: A vesting schedule is also suggested to be included in a founders’ agreement. It outlines the vesting of shares for each founder and provides protection to the company if any co-founder exits the company. Vesting of shares is typically conducted on the basis of time or milestone contributions. In time-based vesting, shares are vested according to the time spent by the founder with the company, whereas, in a milestone-based vesting, the focus is on the performance, contribution and agreed goals that are achieved by each co-founder.
• Restriction on Share Transfer: This clause defines terms related to rights and restrictions on founders for transferring shares of the company. The agreement typically includes a lock-in period, during which each co-founder is restricted to transfer his or her shares. It may also include the process for transferring shares before the lock-in expires, right of first offer for each co-founder, valuation of such shares, anti-dilution rights, and tag-along or drag-along rights provided to each co-founder.

Conclusion

A founders’ agreement is the foundation block for a strong and well-structured company and its potential growth. It lays a roadmap to safeguard each founder against possible disputes. When a founders agreement defines and ascertains founder’s equity, roles, responsibilities, and decision-making rights, it fosters transparency and alignment between the co-founders and the company. A founders’ agreement additionally provides reassurance to future investors by demonstrating a structured approach to manage the company’s growth and facing future challenges and harmony between co-founders. The idea of a strong founders’ agreement is to essentially ensure the smooth functioning of a company, defining long-term strategy for founder protection, affirming company integrity and ensuring founder commitment towards the growth and upliftment of the company.

Article by:- Tushar Gulati - (VP- Corporate Law) & Subham Khanna – (Senior Associate) & Swaranjali Kapoor - (Trainee)