Founder Agreements: What You And Your Fellow Founders Should Be Thinking About
Before you and your best friends start a company together, it is wise to spend some time discussing certain key items that will govern business matters between you and to then put you’ve agreed on in a legally enforceable agreement -- what we would call a “Founders Agreement.” For an LLC, these points are usually included in what is known as the LLC Agreement or the Operating Agreement. For a corporation, a separate agreement - usually called a Stockholders Agreement or Shareholders Agreement - is needed.
By working out these important points in advance, you and your teammates can bring clarity and shared vision to your new enterprise and avoid disputes and potential lawsuits down the road. Among other items, the founders should discuss:
1. Equity Vesting Schedule for the Founders
A vesting schedule sets out how a founder’s ownership stake will vest. The vesting schedule is so important because the business gets to claw back all unvested equity if and when a founder quits or is terminated. The means a founder that thinks the company has any potential has an incentive to keep working and adding value.
Usually, founder vesting happens over time – i.e. monthly, quarterly, annually, or over some other designated period. In other cases, some or all of a founder’s vesting is based on milestones – the founder completes X or Y deliverables like hitting a tech development target or a certain sales target.
While vesting schedules are often the same for each founder, they do not need to be. For instance, if one founder has put in initial capital or brings with them significant IP or has made material progress on a key component of the new business’ core technology, some or all of that founder’s equity might be vested as of day 1.
2. What are the Founders’ Rights to Sell or Transfer Equity
Another key item is the right of the founders to sell or otherwise transfer some or all of their equity to a third party. Some teams may want no restrictions on sales or transfers. Other teams may decide that no sales or transfers are permitted unless everyone agrees. In many cases, a founder may be allowed to sell their shares, but only if the business or the other founders get the first chance to buy those shares (known as a Right of First Refusal).
There is no one ‘always best’ approach to transfer rights – instead, the right choices are the one that works best for your particular business and the priorities of its founders. Your team may be comfortable with transfers and the consequences involved. Likewise, your team may want to keep ownership very much limited to the initial team members and nobody else.
3. A Drag-Along
A Drag-Along provision allows the ultimate decision-makers – the company’s directors or ‘managers’ (for an LLC) or whoever -- and/or the majority owners to require any minority owners to participate in a sale of the company. This can be critically important if you want to be able to sell your business – so often, business buyers are only interested in buying 100% of the business, not less. Without a Drag-Along provision, a minority owner can hold the deal hostage for additional concessions or perhaps kill the deal altogether.
4. A ‘Buy-Sell’ Provision in the Event of Irreconcilable Differences
While the founding team usually starts with a shared vision about their new business, it is common to see a business immobilized when there are two founders with equal decision-making authority and then irreconcilable management disagreements arise. It’s the kind of situation that leads to lawsuits, destroyed friendships, and ruined businesses.
By including a Buy/Sell provision of some kind, the founding team can avoid this situation by creating a mechanism for one founder to buy out another. A very common buy/sell provision for a team of two founders is a “shotgun” clause: one founder triggers the shotgun clause and proposes a price. The other founder then gets to decide whether to sell their stake at that price or buy the other’s founder stake instead.
The reason you agree on something like a Buy/Sell provision when you start up the business instead of waiting for problems to show up is that by the time you have irreconcilable management differences, the two founders are usually so upset and frustrated with each other that almost impossible for them to agree on the details for this kind of mechanism.
5. Minority Founder Rights
Unless a business is split 50/50 between two founders, a business’ ownership and management structure usually mean the majority owner(s) get to make all the key decisions about how the business will be run. Unfortunately, that powerlessness is often a deal-breaker for those founders who know they will end up as minority owners.
Minority Founder Rights are very often used to bridge that gap. These are provisions that say that, for certain key decisions, majority owner approval alone is not enough. For some companies, a particular decision must be unanimous. For other companies, there is a “super-majority” requirement (e.g, 66%/75%/90%-ownership approval required).
Minority Founder Rights can cover a huge range of possible business decisions and actions. Some Founder Agreements include only Minority Founder Rights; others include 15-20+. Common Minority Founder Rights include:
- a decision to sell the business
- a decision on when to get new investors for the business and on what terms
- a decision to wind-up or liquidate the business
- a decision to change any of the key organizational documents of the business (for example, a corporations’ certificate of incorporation or bylaws).
6. Who can fire a Founder and When?
If a founder is getting compensated for working on the business – whether cash, continued equity vesting, or whatever -- you really need to work out in advance the rules for terminating someone on the founding team. Because so much is at stake if you have don’t have those rules worked out in advance, terminating a fellow founder can lead to business-destroying lawsuits and other problems.
In some cases -- for example, when one founder is putting up all the money and owns most of the company -- the other founder agrees to an “at-will” arrangement under which they may be terminated for any or no reason. In other cases, the founders will require an arrangement where they can only be terminated for “Cause” -- for example, not doing any of the required work, being convicted of a felony, or embezzling from the business.
If a founder can only be terminated for a specific reason or set of reasons, it is very important to be careful about how those reasons are written out in the Founder Agreement – this is an item where a few different words here or there can have a huge impact on the business and the founders.
Conclusion
Besides picking great teammates, spending the time to do a Founders Agreement intelligently is probably the best insurance you can have against having your new business – or your personal investment of time, work, and money in the business – ruined by disagreements and uncertainties between the founders. So do yourself and your teammates a favor and take the time to work out these issues and get them down in a binding Founders Agreement.
ASK A QUESTION OR SCHEDULE A MEETING/CALL.
If you’re interested in some of our other very helpful articles for start-ups, please see “Startup Equity Explained: What are Stock Options?” and “Should You Have Advisors For Your New Startup? “.
Disclaimer: This article constitutes attorney advertising. Prior results do not guarantee a similar outcome. MGLS publishes this article for information purposes only. Nothing within is intended as legal advice.