This article is written by Arushi Agarwal, pursuing a Diploma in Advanced Contract Drafting, Negotiation, and Dispute Resolution from LawSikho. The article has been edited by Ruchika Mohapatra (Associate, LawSikho).
A co-founder’s agreement (or a founder agreement or a founders’ collaboration agreement) is essentially an agreement governing the professional relationship between the founders who had started a new business. In the face of options such as a partnership, LLP, company, or a non-profit entity such as trust, society, or a registered non-profit organisation, the question arises that why should anyone consider entering into a separate co-founder’s agreement?
Although some of the above business ventures offer significant flexibility, a major disadvantage of all of them is that they require registration and some filings with statutory authorities, Even a partnership agreement can be quite sophisticated- it can state a lot of details about finances, the operation of bank accounts, admission, and retirement of a new partner, etc. However, in the initial phases, parties usually want to focus on the business and build a pilot or a prototype, so any legal documentation that is entered into must focus more on their immediate needs.
At a time when there is just an idea and where a group of people has come together to try and see if they can build a prototype, it makes little sense to enter into a detailed agreement about a future business. In the initial phases, revenues are often absent and so what is needed is an arrangement to pool funds and build a pilot or a prototype that can be tested and be used to generate some initial users. If revenue-generating potential is identified subsequently, a formal business venture can be adopted, or more elaborate provisions can be inserted into the cofounder’s agreement and the business can be registered as a partnership or incorporated as an LLP or company.
When should the co-founder’s agreement be entered into?
Starting a business requires an investment of time and resources from each co-founder. The co-founder may know each other extremely well personally, or they may simply operate professionally, in either case, it is extremely important to determine certain issues when co-founders decide to come together so that there is clarity on what is expected from each other. Typically, the following issues need to be understood at this stage:
- Decide what is to be built,
- Estimating how much time it will take and ensuring that the co-founders ate committed for that time,
- Allocation of responsibility amongst the different co-founder,
- Knowing how much money is required to build the product i.e., how much each co-founder will contribute,
- If there is feasibility of business, then, determine an agreed profit or shareholding ration in advance, which would be used for incorporation or formalization of the business entity,
- Ensuring that any intellectual property is used only for the purpose of the product.
The essential clauses of co-founders agreement
1. Business definition and milestones
Defining the potential venture of the company is very important. It includes giving a name to your venture and should also encapsulate your goals and should mention what your product/ service offering is. The clause should be accurate and should not be vague. You may have a broad definition followed by a specific definition of a general concept, for e.g.: “providing management advisory services to seed-funded start-ups in order to connect them to angel investors.”
If a co-founder leaves, there may be conditions in the agreement to prevent him from engaging in ‘competing’ business for some point in time and that they cannot use the brand name of the business. Therefore, objectively defining the ‘businesses of the start-up is important.
The co-founder’s agreement will be for a specific duration- a timeline or specific milestones can be specified, for taking decisions on whether there is future business potential in the idea- for example, building a prototype and receiving feedback from 100 users.
The clause may begin somewhat like this:
The following individuals are hereby admitted as partners in the Company (“Founders”)
The Founders have created the Company for the sole purpose of providing management advisory services to seed-funded start-ups and connecting them to angel investors (The “Project”).
2. Economic interest and ownership
Defining current ownership usually increases the risk that the agreement may not be enforceable unless it is registered as a partnership. At this stage, parties can choose one of the following options:
- They can register the co-founder’s agreement with the Registrar of Firms in the state where the business is situated to ensure that it is enforceable. In this situation, they can define the economic interest held by each co-founder.
- Alternatively, they may simply specify the share that the co-founders will have in the future if they agree to adopt a formal structure for the business (depending on the results of the pilot).
3. Intellectual Property and non-disclosure obligations
Intellectual Property in all work must be complete and exclusive; used for the purposes of the business. If a co-founder leaves, he or she must relinquish all rights in any codes, layouts, business plans, marketing and financial plans, and any other content created for the business. Such content can only be used for the purpose of the business. He or she should also not be allowed to disclose any information, details, plans, or insights pertaining to the business of any third party, without written consent from the other co-founders.
The sample clause can comprise the following:
IP refers to (a) contributions and inventions, discoveries, creations developments, improvements, works of authorship, and ideas (whether or not protectable under patent, copyright, or other legal theory) of any kind that is conceived, created, developed, or reduced to practice by any Founder, alone or with others, while such Founder is a member of, or provides service to, the Company, regardless of whether they are conceived or made during regular working hours or at the Company’s place of work, that are directly or indirectly related to the Project, result from task assigned to a Founder by the Company or are conceived or made with the use of the Company’s resources, facilities or materials; and (b) any and all patents, patent applications, copyrights, trade secrets, trademarks(whether or not register), domain names and other intellectual property rights, worldwide, with respect to any of the foregoing.
Each Founder hereby irrevocably assigns to the Company all right, title, and interest in and to all Project IP owned by such Founder. Each Founder agrees (i) to assist the Company from time to time with signing and filing any written documents of assignment that are necessary or expedient to evidence such Founder’s irrevocable assignment of Project IP to the Company; and (iii) to assist the Company in applying for, maintain and filing any renewals with respect to project IP anywhere in the world, in each case at the Company’s expense.
4. Mechanism to determine ownership or economic interest
Various methods can be used to determine ownership, such as:
- Equal division of interest depending on the number of co-founders.
- Division based on effort- Let’s say there are 4 co-founders. In that case, a part-time co-founder or a co-founder who is not working on the core tasks such as product creation or marketing/ selling gets a 100% stake in the business while remaining three performing core activities will get 30% stake each.
- Based on the amount of capital contributed- This decision ignores future ideas, efforts and contribution which may vary across different co-founders.
Ideally, a combination of the above methods should be used to determine economic interest. Hence, the amount of capital contribution, the amount of effort, the relative value of the task or responsibility taken up by the co-founder, and ensuring that some level of parity is maintained amongst the different co-founders are key factors to determine the equality split.
Founders either lose interest or get a better opportunity and wish to exit the business or are ousted. The remaining co-founders in such a scenario, need to secure equity in the venture/ business. For this purpose, the stakes/ capital of the co-founders is vested in the business for a particular period. The founder’s agreement with the vesting of the shares can include vesting of shares in the following ways:
- Time-based vesting i.e., the shares will be vested in the proportion of the time spent by the founder.
- Milestone vesting i.eThe vesting will take place when the company achieves a milestone.
The clause may look something like this:
Vesting will occur based on the following schedule:
- Until and through [First Vesting Date- 1 Year], neither Founder’ shares will vest (“Cliff Period”).
- On and not before [First Vesting Date- 1 Year]- [25%] of each Founder’s shares will vest
- On and not before the 1st of every month thereafter, [1/36th] of the remaining [75%] will vest
- Thus, on [End Date] (the Full Vesting Date”), each Founder will be 100% vested.
If either Founder ceases to provide services to the company, resigns from the Company or is terminated from the service of the Company by the majority vote of the Founders according to their respective ownership interests with or without cause or good reason (“the Terminated Founder”) at any time prior to the Full Vesting Date (“the Termination Date”), none of the Terminated Founder’s additional shares shall vest. The Terminated Founder’s remaining unvested shares as of the Termination Date shall be cancelled or returned to the Company, and the Founder’s ownership interest shall be reduced by the number of unvested shares so cancelled or returned.
6. Roles and responsibilities
- Who is responsible for product creation?
- Who should deal with investors and prepare pitch documents?
- Who is responsible for marketing?
- Who is responsible for the website and design?
- Who is responsible for customer support?
- Who is responsible for the user-interface?
Responsibilities amongst the co-founders must be mutually allocated. It is important that roles and responsibilities are clearly defined for each of the co-founders based on what each of them brings to the table. Typically, the roles and responsibilities can be divided into operations, sales, and marketing, administration, finance, etc.
7. Decision-making process
How should conflicts be settled? Who has the final say in the event of a business disagreement on business strategy? Although in the initial stages, founders tend to have an implicit understanding of one another, differences can arise from time to time. If differences cause friction or take time to resolve, it can reduce the overall operational efficiency. For example, what if there are differences over the following issues:
- Should the company follow a B2B or a B2C model?
- Should it focus on building offline channels or om online marketing?
- Should it focus on international markets or the domestic markets?
- Should it diversify now or take the product to the next level?
These questions need to be resolved through a clear decision-making process. Therefore, a clause allocating responsibilities can be included in the co-founders’ agreement which should be used as a guideline for decision making. A voting procedure amongst the co-founders could also be inserted. If a voting process is followed, decisions could be taken by most of the co-founders where each co-founder’ vote carries equal weightage or through a weighted vote, where the voting power corresponds to the percentage of the economic stake that each founder holds.
8. Performance criteria and firing
Firing is a sensitive issue and difficult to deal with in a written document. Business frequently fails to achieve targets, but that would not necessarily lead to the firing of a co-founder. Therefore, firing needs to be addressed in a broader way. If it is unaddressed, lack of participation from one of the co-founders can cause slack amongst each other, as the others will see themselves working extremely hard while one of the co-founders is not involved. Co-founders should try and lay down the circumstances under which all of them agree that the ouster of a founder member would be justified.
A voluntary provision to enable co-founders to leave can be incorporated. Co-founders may agree to a process where if a co-founder leaves or is fired before the completion of a specified amount of time, the economic interest of the outgoing co-founder reverts and is proportionately distributed amongst the remaining co-founders.
9. Dispute resolution and conflicts
The co-founders must also specify within the agreement the method which is to be adopted if there are serious disputes or breakdown in the relationship between the founders which is not settled. The disputes need to be resolved quickly and cheaply for the business to continue. One cannot let the possibility of approaching the courts which always remained open. An arbitration clause can be inserted for such situations. A sample arbitration clause is-
“All disputes arising from or related to this Agreement must be referred to mediation involving one mediator mutually decided between the Founders.
In the event, the mediation fails, the dispute may be subjected to arbitration before a single arbitrator under the Arbitration and Conciliation Act, 1996 as in effect at such time. The seat and venue for such arbitration will be in New Delhi, India.
Any resulting arbitration award may be enforced in the courts of New Delhi. In addition, the Founders hereby irrevocably submit to the jurisdiction of the courts of New Delhi for the enforcement of any such arbitration award.
10. Non-compete restrictions
A co-founder’s agreement should include an obligation prohibiting co-founders from starting work on the same idea in case they leave, retire, or are expelled from the business. However, strategic disagreements on the product can make co-founders visualize different products that pertain to the same space. For eg- imagine a Facebook co-founder leaving to start a website like Twitter. Are these competing businesses? They are in the same space, that is, social media, but probably each one has its own niche and does not really eat into another’s market share or has a different type of customer because each of these tools is used for different purposes. However, Orkut and Facebook are much closer substitutes. There can also be terms to prevent founders from working with suppliers and vendors of the initial company. The sample clause is-
“ Each Founder hereby covenants to the Company and to the other Founder that he will not, directly or indirectly, engage in any activity whether as an employee, consultant, contractor, officer, director, stakeholder, partner, investor, representative agent of any entity or otherwise, which competes in any manner with or is adverse to, the business of the Company in the Fields of Activity, for as long as he is a director, officer, employee, consultant or the holder of more than 5% of the Company’s then outstanding share capital and for one (1) year thereafter.
11. Provisions for compensation
Provisions for reimbursement of costs that are incurred personally by the co-founders for the business are personal living expenses along with the mechanism for sharing any revenue that is generated, which can be specified.
12. Exit mechanism
The agreement must define how a co-founder may leave the organisation. This also includes the provisions relating to the removal of a co-founder i.e., the situations in which a co-founder may be removed and the procedure to be followed during and after the removal.
13. Enforceability risks
The co-founder’s agreement is intended to be extremely simple and to be used at extremely preliminary stages of a business, at a point where the co-founders do not contemplate detailed legal compliance and documentation.
However, if a co-founder’s agreement is understood as a partnership by a court, its enforceability may be difficult. Partnership agreements are only enforceable if they are registered with the Registrar of Firms in the state where the business is carried out to be enforceable. There is a chance that the provisions governing the economic interests of the co-founder and capital contributions lead the court to infer that it is a partnership.
How should you ensure that your co-founder’s agreement is enforceable?
A co-founder’ agreement is typically ideal for the stage before a business has come into existence, that is when the product or service is being created. At this stage, there are barely any revenues or profits in existence. Therefore, the agreement primarily focuses on provisions to govern the professional relationship amongst the partners that is necessary for building a product or service, without focusing on profit shares or risk-taking abilities. Typically, it contemplates that the co-founders agree to come together and work on certain agreed principles to build a product/service They may contribute certain financial sums for bearing the costs of the business.
From the moment where a clear revenue stream is imminent or profits are in sight, the co-founders can contemplate three actions:
- Entering into a formal partnership agreement which is much more detailed and getting it registered with the Registrar of Firms.
- Incorporating the business as an LLC or a company. Key terms of the co-founder’s agreement can be incorporated into the LLP agreement or the company’s articles of association.
- Amending the co-founders’ agreement to provide for more detailed provisions on profit sharing and proceed for registration of the co-founder’s agreement as a partnership agreement with the Registrar of Firms so that there is a certainty about its enforceability.
The co-founder’s agreement can state that if subsequently a formal legal structure is adopted for the venture that is carrying out the business, the co-founders will ensure that the shares or mutual holdings as specified in the co-founder’s agreement.
Starting a new business is an exciting time for any entrepreneur. However, many times co-founders make the mistake of ignoring important things like creating an agreement among themselves outlining each one’s duties and responsibilities. A co-founder Agreement is a contract between co-founders detailing various things like initial capital contribution, duties, and responsibilities of each co-founder, amongst others. This agreement also acts as a safeguard in the case of a dispute, as it can provide protection to show what the co-founder agreed to in the first place. The benefit of a co-founder agreement lies not only in the fact that it formalises the relationship between the founders but also in providing guidance on how to deal with roles and responsibilities, commitments as well as any contingencies that might arise in the future.
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