In this article, V Surash Babu pursuing Diploma in Entrepreneurship Administration and Business Laws from NUJS, Kolkata, elaborates on kinds of dispute resolution mechanism that should be incorporated in Shareholders’ Agreements and Co-founder Agreements.
Starting a new venture has its own inherent risk. People having same ideas, same passion, same thinking will come together, put their hard earned money and hard work on their dream idea to make it a great success. So a written agreement between the members of the founder team that clearly spell out roles, responsibilities and functions of the of each founder member. Such an agreement, Co-Founders agreement should be incorporated in the very early stage of its existence.
In Indian contest many time the founders neglect this vital aspect of making this internal document signed by them to draw the broader vision, mission, roles, obligation, responsibility objectives of its members to convert their collective idea into a winning reality.
A well-drafted co-founder agreement help to nurture the working relationship among its founder, help in align every member goals with that of their start up’s. The founders’ agreement is a legal binding agreement between the founders of the company but doesn’t involve any other third party like investors or creditors. A Co-Founders agreement should address all unforeseen events to avoid chances of potential and disruptive conflict between its members in future. So the Co-Founders agreement and to a large extent shareholder agreements basically set down the rules and principles over which the firm should exist, internally managed towards faster growth and value creation.
Also, this Co-Founder agreement gain real importance in the later stage of the business, as many potential investors look this document critically before making decision to invest. Even though AoA can address many issues of the newly incorporated firm, still AoA cannot be considered as a replacement of or substitution of Co-Founders or shareholders agreement, as articles of association bind the company and its members in their capacity as shareholders of the company only and not in any other capacity in the company. Also, articles of association of a company are public documents and are open to inspection, hence not suitable document to discuss on internal management and control functions of the company. In addition to that Articles of Association can be amended by way of a special resolution passed by 75% or more majority. By contrary, shareholder agreements and co-founder agreements require unanimous agreement to incorporate the modifications.
The following areas can be considered as the key domain where clear terms of reference will be made available in a well-defined co-founders agreement.
Roles, Responsibilities & Accountability
The roles and responsibilities of each member should be clearly placed in the agreement to avoid chances of future misunderstanding among the team members. For example in a starts up to produce an electronic stabilizer, the roles such as design & development of the stabilizer, its mass production, selling the product, arrange finance to purchase the raw material etc should be clearly defined and demarcated between the members.
Decision-making
As the start up grows, decision making become more and more complex. So the agreement should adequately address this issue of decision making for smooth functioning of the firm and to avoid delay and conflicts in decision making process. For instance, agreement shold address, how are key decisions and day-to-day decisions of the business to be made, majority vote or unanimous. What are the areas where decisions solely in the hands of the CEO? Who will have the authority to sign cheques? Who can approach investors or enter into important contracts on behalf of the business? etc.
Equity Ownership
Each Co-Founder’s equity must be defined clearly in the agreement. To split equity equally between cofounders or dividing proportionally to depending on who brings what to the company. How the factors such as experience, technical know-how, marketing network, financing the firm of the members are taken into consideration in percentage of share allotment to each member.
Intellectual Property
Intellectual Property comes in many forms but it’s important to make sure that whatever IP is being developed for the new enterprise it belongs to the entity and not to the individuals behind such development. So the agreement adequately discusses this issue of IP and included the clause like “whatever inventions, design an individual do for the firm, should remain the property of the firm”.
Non-Compete
The co-founder should not undertake any activity, such as starting another firm, offering similar product or services, becoming the shareholder of a competing company, which affect the fortune of the firm. The agreement should have clear deliberation on this conflict of interest area.
Confidentiality
Agreement must include terms to prohibit the members and fix the accountability, on the members on leaking sensitive business related matters to outside which may adversely affect the business operations.
Conflict resolution
In case of any disagreement on certain issues raised among the founder members, resolving the issue is very important for sustainable development of the firm. Hence, agreement should have provision to resolve the conflict. Agreement should stipulate a strong and clear, predetermined mechanism for dispute resolution which can resolve the issue quickly without causing any damage.
Vision of the business
Overall goal and vision of the existence of the company should be incorporated to make the team focused. It helps the cohesion between the members to achieve the common goal.
Transfer of Shares
Existing shareholders, the founders, generally want to ensure that unwanted parties do not become shareholders involuntarily as a result of any of the above such as member becomes bankrupt, discharged, resigns, retires, becomes incapacitated, or dies. Hence it is important to include these aspects also in founder /shareholders agreement. The agreement should have provisions to regulates the sale and transfer of the startup’s shares. It covers items such as who has the right of first refusal and provides a mechanism for the redemption of the shares for shareholders, who.
Value Additions
The agreement should deliberate clearly about the how to compensate the co-founders who bring value addition to the firm. For example, members can bring value addition in terms of IP, Technical Know-How, marketing network etc.
Compensation
Founder members are more than the full-time workers of the start up. Hence agreement should have clarity in terms of employment, compensation, fringe benefits of each co-founder members proportional to their contribution of revenue generation and growth of the firm, mechanism to change the compensation package from time to time according to the profit generation also should be there in the agreement.
Removing a founder member
Even this looks sensitive issue while the starting point of the firm, but clear terms on this also there in the founders agreement. It should address what grounds a member be removed, the due procedure to be followed, the compensation to be made available to that founder. For example, if one founder member found to be underperforming and dragging the business down or not living up to expectations or committed fraud. Agreement should have clear terms to deal such situations.
Exit strategy
Co-founders generally never think about exiting a business, but due to some personal or other, positive and negative reasons, one of the founder wants to leave. Hence it is important to meet such an eventuality, and the agreement should have adequate provisions for the exit of a co-founder before the lock-in period. The agreement should spell out clearly on what is going to happen to the money that the co-founder have invested, the equity the leaving member. Sale the shares to a Third Party, or to the other members, price on which the shares to be transacted.
Exit in case business shuts down
The questions like what circumstances will the co-founders agreement be terminated? What if the business does not take off and becomes unviable? How will founders distribute assets, liabilities and any money left in the business, etc, even though it looks unpleasant to the founders in the beginning, should also be adequately covered in the agreement.
Expected minimum time commitment
Hard work with devotion of all members is essential for successful establishment of a firm. Hence co-Founders generally prohibited to do other works. The agreement should have clear guidelines on the minimum time commitment from each member to the growth of the company.
Deadlock resolution
If a deadlock reached on a certain important issue and there is no provision in the agreement to deal with it, it may cause serious repercussions in the functioning the company. Hence before reaching such deadlock situation and gravely suffer it is always better to include adequate provisions to handle such situations in the agreement.
Finance
Frequently early stage companies will not be sufficiently cash generative to meet the working capital requirement. If this initial capitalization together with available cash flow is not sufficient, and sometimes forced to avail loan from third party. Agreements has to lay out clear terms to deal situation such as loan capital, the provision of founder personal guarantees to support bank facilities. A shareholders’ agreement may also provide for what is to happen in the event that a party defaults on its obligations. It should be clarified how loan received from founders will be treated. It may be paid back with or without interest, or may be compensated by issuing shares of the incorporated entity. Also agreement should have clear understanding regarding the reimbursement of out-of-pocket expenses.
Division of profits
Profits are another crucial aspect that must be deliberated over in the agreement. How the profit generated should be shared between the members.
Induction of new members
Induction of new co-founders can be very sensitive issue. This should not become a bone of contention between co-founders and lead to decision paralysis. Co-founders agreement should include specific provisions for addressing this.
Minority Protection
Generally the standard articles of association gives extensive powers to the board of directors to take decisions. The Companies Acts and AoA provide limited rights for minority shareholders. Hence it is always recommended to include clauses to protect the interest of minority share holders for a healthy growth of the company in its later stage of life cycle.
Conclusion
A well drafted shareholders agreement sets out the framework within which a company intends to operate. It include provisions which address matters such as the management and control of the company, funding structure, exit strategy, dispute resolution and a deadlock resolution etc.
A balanced agreement establishes in clear terms of relationship between the Co-Founders. And more importantly, for Investors it acts as a guiding document to judge the governance mechanism in the Company. One of the best ways to minimize the probability of co-founder dispute is by drafting appropriate provisions in the agreement by respecting the interest of all the parties. Therefore, not having a rational and balanced Co-founders Agreement can cause enormous hardships and jeopardize the viability f the new enterprise in long run.
