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Why a Founders’ Agreement is important for every small business

September 28, 2021
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This article is written by Faith Kantono, pursuing Diploma in Advanced Contract Drafting, Negotiation, and Dispute Resolution from LawSikho. The article has been edited by Anahita Arya (Senior Associate, LawSikho) and Dipshi Swara (Senior Associate, LawSikho).

Introduction

If you are planning to start a business, it is important to know that the business may not become as successful as you have planned for it, if you do not create a strong foundational structure for it. You may be excited about getting together with friends, family or colleagues to leverage your strengths and turn your great ideas into a successful business project, you may be looking forward to a blossoming business in order to reap the economic benefits of its growth. However, you need to stop and think about the possibility that the business may totally fail due to one major problem- you failed to create a management structure with your friends, family or colleagues when you ventured into starting that exciting business. You basically did not give the business direction or a foundational plan. In order to protect yourself from this disappointment, there is a need for the founders of the business to discuss crucial details about how the business will be run or managed by them. This discussion should be reduced into writing in what is known as a Founders’ Agreement.

This write-up will help the owners/founders of any business start-up to appreciate the importance of executing a Founders’ Agreement as a very important step preferably before they establish or incorporate a business.

Many entrepreneurs may start up a business without knowing the implications of not having a foundation on which each owner’s interests in the business are protected through an agreement.

The article will therefore cover the scope of the agreement including the important questions the founders must discuss before the business is established., the important clauses of the agreement, benefits and the importance of this agreement.

Who is a founder?

A founder is a person who starts their own company. They are the ones who come up with the business idea and act on it. For example, Jeff Bezos is the founder of Amazon, one of the world’s largest online business shopping centres. In business, a founder is a person who comes up with an idea and then transforms it into a business startup. Two or more persons can be known as founders. A small business is defined as a privately owned corporation, partnership, or sole proprietorship that has fewer employees and less annual revenue than a corporation or regular-sized business. Some examples of small businesses may include catering services, hairdresser services, cleaning services, among others. A small business is also referred to as a company when it is fully registered and incorporated into a company according to the laws that govern the incorporation of a company. The founders are therefore the top-level managers who are responsible for controlling and overseeing the entire business.

This agreement is therefore very important to guide the smooth management and operations of the business during its lifetime. The goals of the business are achieved better through a solid foundational structure for its management which the founders must strictly follow. It is a mutually agreeable framework that shall serve as the foundation for the Founders to successfully develop their business concept.

As a founder, you need to know what a founders’ agreement is in detail, the scope of this agreement, the important clauses in this agreement, its benefits and the importance of having such an agreement.

A brief insight into Founders’ Agreement

It is important for a company’s founders to discuss amongst themselves what their business concept and strategy is even before creating an entity. A Founders’ Agreement is a product of conversations that should take place among a company’s founders at the early stages of formation rather than later during the life of the company.

The goal of these conversations is to have an open and honest discussion about the expectations, attitudes, fears and aspirations of individuals involved with the start-up, so as to minimize the likelihood of heated conflicts or disagreement as the company continues to grow. The outcome of these discussions should be to have each founder’s business interests protected.

What is a Founders’ Agreement?

A Founders’ Agreement is a contract that a company’s founders or owners enter into which governs their business relationship. It is a document, involving a company with two or more founders, specifying the details of the management and administrative structure of the company, such as the share of ownership and guaranteed obligations of the different founders. It is legally binding and maybe a standalone document or it may be incorporated into corporate bylaws, an LLC operating agreement or a partnership agreement. It is designed to protect each founder’s interests and to prevent conflict between or amongst the founders when operating the business.

The agreement lays out the rights, responsibilities, liabilities and obligations of each founder. Generally speaking, it regulates matters that may not be covered by the company’s operating agreement. Ultimately, Founders’ Agreements are designed to protect each founder’s interests and ensure that all founders are in agreement about the venture’s basic structure and how the founders will work together to move their business forward. Forging an agreement between all founders helps mitigate the risk of a lawsuit over who owns the business.

Scope of the Founders’ Agreement

As earlier noted, the founders should have a conversation or a discussion on what their interests and expectations are in terms of the general structure of the company. Their discussion will cover the scope of what the founders will agree upon or what they should have in mind. Below are some of the important questions that the founders should discuss in order to have a comprehensive agreement that will protect their interests and avoid any future unnecessary conflicts.

The strategy of a Founders’ Agreement

  1. What is our overall vision for the start-up?
  2. What goals do each of us have for the start-up? What goals do we have for ourselves?
  3. What objectives should we consider in order to achieve those goals?
  4. What are our respective timelines for achieving these goals?

Ownership structure

  1. What will we each contribute to the company? Should this be valued in terms of a percentage interest in the company?
  2. How much capital are we each contributing and how will it be spent?
  3. Should we consider making personal additional capital contributions to the business if it is struggling financially?
  4. Is the percentage of ownership shares subject to vesting based on continued participation in the business?
  5. How many shares are we each buying into the company?
  6. Who owns the Intellectual property of the company?

Management

  1. How are key decisions and day-to-day decisions of the business to be made? Should we decide by majority vote, unanimous vote, or should certain decisions be solely in the hands of the CEO?
  2. How should we handle disputes?
  3. How often should we have meetings to discuss company matters?
  4. What remuneration/salaries are we entitled to? How can that be modified as the company grows?
  5. Who should take up certain roles or positions and why? Which positions should we create?
  6. What are our responsibilities?
  7. What happens if one of us wants to leave?
  8. If one founder leaves, does the company or the other founder have the right to buy back that founder’s shares? 
  9. What happens if one of us wants to sell the company, raise money, lend money to the company or dissolve the company?
  10. What happens if one of us becomes disabled or dies?
  11. Can we each launch other startups while working on this project?
  12. Can any of us start a business similar to this one once this one dissolves or does not succeed? What about if one of us leaves and the business is still running, can they start a similar business?
  13. Under what circumstances can a founder be removed as an employee of the business?
  14. What happens if one founder is not living up to expectations under the founders’ agreement? How would this situation be resolved?
  15. If it turns out the business is not taking off and we decide to end our venture, can one of us take the idea and try it again?
  16. If we need to raise start-up capital, where will it come from and how much of the company are we willing to give in exchange for that start-up capital.

Importance of entering into a Founders’ Agreement

  1. It governs the founders’ business relationships. It acts as a guide for the business relationship between the founders. In this way, it spells out the roles, rights, responsibilities, liabilities, obligations and share of ownership of each founder in the business.
  2. It protects the founders’ interests and ensures that all founders are in agreement about the business ventures’ basic structure.
  3. It ensures that the founders are in agreement about how they will work together to move the business forward.

Benefits of having a Founders’ Agreement

  1. It aids in harmonious management or running of the business by the founders.
  2. It guarantees the security of ownership of the business since each founder will know their stake/share in the business.
  3. It puts in place parameters for the management of the business by the founders.
  4. It minimizes conflict between and amongst the founders when managing the business.
  5. It helps to mitigate the risk of a lawsuit over who owns the business.
  6. It guarantees the growth of the business since the goals of the business and the business relationship of the founders are clearly spelt out.

It is important to note that failure to have such an agreement leaves huge management and administration gap. The founders of the business will each do what they please or believe is right for the business which opens room for conflict and hence the collapse of the startup.

Important clauses in a Founders’ Agreement

1. Nature and type of business 

This clause should describe the nature and type of business entity that the founders are incorporating. This defines the main purpose of this agreement, for example, that the founders have teamed up to incorporate a marketing and advertising start-up. This clause may also cover the objectives of the business start-up as agreed by the founders.

2. Business strategy

The founders’ business strategy should clearly be defined. This should define the vision and mission of the business entity. The goals and objectives of the business should also be spelt out here. The founders should have a discussion on each one’s goals and expectations of the start-up, their targets and how they think these can be achieved which will all be merged under this clause.

3. Ownership structure

Every founders’ agreement must spell out each founder’s contribution to the business start-up. This includes the percentage interest contributed or the number of equity shares held by each founder. The founders may agree to contribute equally to the capital of the company. For example, if the company’s authorized capital is agreed at Rs 1,00,000, it shall be divided into 10,000 equity shares of  INR 10 each. This would mean that in the case of two co-founders, each will be allotted 5000 shares and shall therefore each have a 50% shareholding in the business. They may further agree to have the same rights and liabilities in all respects regardless of the shareholding.

4. Roles and responsibilities

It is important to assign clear roles and responsibilities to each founder depending on their area of expertise. For example; founder 1 shall be responsible for consultancy relating to business development, day to day operations and management. Founder 2  will be responsible for sales and marketing while founder 3 shall be appointed the Chief Executive Officer (CEO) or Managing Director. It is also necessary to specify that the company shall be managed by a Board of Directors(“Board”) which shall constitute all the founders to be referred to collectively as directors.
This clause encourages efficiency since each founder knows what is expected of them. This also leads to the development of a system of accountability whereby it is easy to identify a particular founders’ responsibility for a particular task. If the roles are not specified then there will be room for conflict amongst the founders in terms of who takes responsibility for certain tasks.

5. Decision making

This clause defines the mechanism put in place to guide the members on the decision making procedure for general issues. There is a legal presumption that each share in a company provides the owner with the same rights and liabilities as every other share. This is called the “presumption of equality” (this presumption can be displaced by the company issuing shares with different rights attached to them). Each founder in this case is entitled to one vote each (voting rights) with respect to decisions regarding the day to day management and operations of the company.  

The founders shall endeavour to make all strategic decisions and budget approvals unanimously. If this is not possible then decisions shall be determined by the majority vote of the founders. Major decisions related to bringing investment or funding, mergers, business collaborations, among others, shall be determined by voting of the founders. The number of votes cast by each of the founders shall be in proportion to their shareholding in the company where each share corresponds to one vote. This clause should therefore be all-inclusive and capture the entire decision-making strategy for general and major decisions.

6. Transfer of shares

This clause answers the question of how a founder’s shares should be handled in case they want to leave the business or if they plan to sell their shares. What should be the process of having their shares transferred? Will the company buy back those shares and how will the directors/founders be involved? This clause may put a restriction on the sale, transfer, assignment, pledge or disposal of shares without the written consent or approval of the other founders.  

7. Remuneration

The agreement should clearly lay down the payment scheme. The question is how much should each founder be entitled to and how often should this payment come in. A decision on how the remuneration will be determined should also be included. This should also include a notification that this clause will be modified by mutual agreement depending on the growth of the business entity. This clause is crucial because it avoids any upcoming dispute in relation to each founder’s entitlement after their hard work and contribution to the success of the business. 

8. Ownership of Intellectual Property Rights

As the company grows, it acquires property that identifies it as its own unique business entity known as intellectual property. The founders must therefore assign exclusive ownership of all the acquired intellectual property and rights there-under to the company. This property may include trademarks, trade names, patents, copyrights and trade secrets that are necessary to operate the business. This clause is very important because a dispute could arise where a founder claims ownership of the intellectual property of the company since they brought the idea or created it or were substantially involved in its evolution.

9. Resignation and removal of a founder

The founders must agree on the circumstances under which a founder can be disqualified and removed from the company. The procedure taken by the founders to exclude such a founder must also be spelt out. The company is bound to follow the Articles of Associations or Regulations that govern companies under the Companies Act, 2013 in terms of the procedure to be followed. The majority of founders or shareholders are responsible for making this decision. Some grounds may include incompetence, mismanagement and misappropriation of funds, among others. 

A founder should not be tied to the company if they decide to leave or resign. Any founder may resign from the partnership in the company for any reason or no reason at all by giving written notice to the other founders. This clause should therefore spell these circumstances out.

10. Representations and warranties

Each founder represents and warrants that he or she is not a party to any other agreement that would restrict such founder’s ability to perform its obligations as set forth in the Founders’ Agreement. Each founder represents and warrants that no third party can claim any rights to any intellectual property or other proprietary right possessed by that founder as it relates to the business concept.

11. Confidentiality

Under this clause, the founders will spell out what amounts to sensitive business information which should not be disclosed to the public except by agreement. The founders will further define any and all confidentiality obligations related to the business concept within the agreement. For example, if the business is a fast foods hub or restaurant business in nature, they may agree that their special recipes for certain foods which are not known to the public are confidential except to third parties where it is legally acceptable to disclose such information. A famous example is a recipe for coca-cola soda which is a trade secret to this day and only known to the founders. 

12. Non-compete

The founders here shall agree that a founder shall not engage in activities that are in conflict with the company’s business. This means that should a founder decide to leave the company, he or she shall not engage in a business venture which is in direct competition with the company for a specified number of years after their exit. For example, it can be specified that for a period of two (2) years after their exit, the founder shall not engage directly or indirectly (through their agents) with an entity or in an activity that will compete with the company’s business.

13. Additional capital contributions

This clause is important to show that any founder may make additional capital contributions in form of cash and prepaid expenses to the company from time to time where there is a need for funding its ongoing capital and operating needs with the written consent of all other founders. It is not mandatory for a founder to make such contributions and that is why the written consent of the other founders is necessary.

14. Term and termination

It is important for the founders to discuss the circumstances under which this agreement will come to an end. This clause specifies the effective date of the agreement from the date it is executed or signed by the founders and it reflects that the agreement shall be valid until it is terminated for example by execution of revised agreements between the founders or through mergers and acquisition of the company. The founders here agree to dissolve the company by unanimous consent through winding up its affairs. They may also agree to jointly terminate the agreement at the time of their exit from the company and they will no longer be bound by it.

15. Dispute resolution

This clause lays out the mode of settlement of any disputes that may arise between the founders. This will guide the founders on how to deal with contentious matters which may not easily be decided by a unanimous decision. The founders may choose the most appropriate mechanism including negotiation, meditation, arbitration and litigation or recourse to the court.

16. Governing law and jurisdiction

This clause clarifies the laws which will govern that agreement in general and the laws to be followed in case of dispute resolution. The agreement is normally governed by and construed in accordance with the laws that govern the state or country where the company is founded.

Conclusion

It is crucial for every founder to consider having a Founders’ Agreement to protect their interests in the business. You do not want to invest your hard-earned money into a business venture only for it to crash because you did not put in place parameters to guide the business’ operations.  This agreement focuses on only the top managers/owners in terms of how they agree to run the business, who is responsible for what role, what are their rights, what are their obligations and liabilities, what are they entitled to, among others. 

The structure of governance of the business should be put in writing to ensure smooth operation and running of the entire business in order to achieve the major goal of building a successful enterprise. The aspect of management and administration should be nipped in the bud from the start of the business and should never be left to a gamble or speculation that the business will succeed on its own due to the combined expertise of the founders.

References

  1. https://www.lawyered.in/legal-disrupt/articles/importance-founders-agreement-start-/
  2. https://www.fundera.com/blog/founders-agreement
  3. https://www.chgtoday.com/founders-agreement-why-is-it-important-for-small-businesses/
  4. https://www.docracy.com/6348/founders-agreement-template
  5. https://www.pandadoc.com/founders-agreement

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