Everything you need to know about preparing a
Founders Agreement for a New Startup
+ Templates, Samples, Founder’s Agreements and more
► Startups and Ventures Practice
► Basics of Founders Agreements
Founders agreements can be one of the most important tools for a new start up, or existing startup that is on the verge of receiving investment funds. A founders agreement helps establish the basic rights of founders with respect to early-stage, pre-seed, and seed stage companies. The point of the founders agreement as to capture the material deal points about how the business is to operate, and who will be doing what, before the up company receives significant outside funding, customers, revenue, or takes on risk.
If you are a founder looking to prepare a founders agreement, or are cofounder negotiating the terms of a founders agreement that has been presented to you, we have put together this comprehensive guide to help you through the process, go over the most common deal points, and you also find samples, checklists, and even an option for custom form if you need professional help.
► Why Have a Founders Agreement?
One of the big questions that founders always ask themselves when doing searches and looking for more information about founders agreements is whether they really need one. In a review of what others have to say about the topic, it’s not difficult to see why founders come to this conclusion. Most of the literature on founders agreements online have to do with spelling out responsibilities, who will be doing what, will be in charge of decision-making, and what the goals of the startup will ultimately be. In our experience, these are actually none of the issues that cause the greatest amount of heartburn for new founders. However, the reality is that having candid discussions about difficult issues can be uncomfortable, and for that reason, many founders agreements focus on issues and content that is not ultimately that significant or consequential, and failed to address the real issues that can cause the greatest amount of controversy and headache for new founders. So, the purpose of this overview is not to regurgitate the other material that can be found online, but to provide a candid discussion of the issues that really must be covered in a founders agreement, if the founders are to protect themselves. Founders agreements are similar to prenuptial agreements – no matter how much the newlyweds discuss what their goals are, or who will be doing what responsibilities, these discussions miss the point because the real purpose of a prenuptial agreement is to protect each party, their rights, their assets, and their belongings, in the event the marriage ultimately does not work out. Founders agreements are the same way. They need to cover the most important issues, or else they will end up largely being worthless.
► What Should Be in the Founder’s Agreement – Points You Already Know About
You probably already know from reading all the other articles on founders agreements about the topics that should be covered. These are as follows:
- Roles, Responsibilities, Authority. What will your duties involve? What will your cofounders duties involve? In the legal context, the formation of a startup always involves appointing officers who are actually responsible for the organization, including the CEO, COO, CMO, CFO and other C-level executives. Sometimes, taking on a designated level of responsibility can seem overwhelming, but it is important to have realistic expectations from people you will be doing business with. After all, businesses are not hobbies. Running a business requires your business partners to be reliable, trustworthy, responsive, and demonstrate a level of commitment. It is too often that we receive calls from founders thing that they need to dissolve their startup because the cofounder has gone AWOL and is completely incommunicado. Having a cofounder who is afraid of taking on too much work at the outset is generally not a good sign. You should reevaluate whether you feel like you can trust this person because the level of work and responsibility does not go down, it increases exponentially.
- Decision-Making. Most startups try to be democratic in nature, giving votes to the founders to be able to decide on various business issues that come up from time to time. However, voting can become more complicated when the founders are contributing different things. In many cases, founders are split between devoting time and effort, talent, such as technical expertise, or devoting and contributing funds to the enterprise. Sometimes there can be disagreements between founders who devote time and legwork versus those who contribute substantial funds. In many cases, investors are founders they contribute the money want to have a bigger say in what the business does or does not do, they bear financial responsibility and are the ones that stand to lose their income if the venture does not work out.
- Vesting, Milestones, Cliffs. There is a lot a literature online about the importance of setting up vesting provisions, cliffs, and milestones, to ensure that founders do not receive a big chunk of the equity of the company, and then drop dead and disappear, and become useless, while still retaining all that equity. The purpose of the vesting provision is to ensure that equity vests over a period of time, so that the founder has to earn all of their shares over a period of time, such as 2 – 4 years.
- Other Common Points
- The name of the startup
- Whether it will be a Corp., LLC, etc.
- Where it will be founded
- Confidentiality provisions
► The Stuff (We Think) Matters
The above points are largely standard and largely noncontroversial. However, in our experience, there are an entirely different set of issues that constitute the majority of disputes between founders in the months and years after a startup emerges. They are as follows:
Voting Structure. Founders generally are unaware of the importance of setting up voting structure correctly. It tends to be assumed that each founders should have an equal vote in how the essence operates. However, changes to the voting structure can have a big impact on the business, and dramatically change how the start of operates, and whether it will be successful.
There are essentially 2 ways to set up voting structure: one person one vote, or one vote per share or unit held. Generally, it benefits the party that is contributing time or talent to have voting done one person one vote, and it generally benefits individuals contributing money to have one share or unit held. To give an example of the differences:
Assume there are 3 founders: Adam contributes services and receives 24% of the business; Bert contributes services and receives 24% of the business, and Charlie contributes $100,000 and receives 52% of the business.
One vote per person: each founder gets a vote, and Adam and Bert can out-vote Charlie 2-1, even though Charlie has more shares than either of them, and is the majority business owner.
One vote per unit held: each unit/share gets a vote, and Charlie’s decision will always control, because Charlie owns 52% of the company, even if Adam and Bert (who are 2/3 of the founders) disagree with him.
So, as seen from the example above, how the voting structure set up can make a big difference on how business actually gets done, and who has the authority to do what.
Division of Intellectual Property
Most startups and founders began working with each other without assigning their intellectual property to the venture. A lot of times this is simply because it is too time-consuming and expensive to start a new business entity, such as a C Corp. or LLC, during the startup’s development. Founders generally want to avoid getting trapped in a situation where they have spend the time and money into developing a business entity and then keep getting hit with taxes and franchise fees year after year, without actually having investment money to the project forward. So, founders generally begin on a project and a new startup without an actual corporate structure. This usually results in no assignment of inventions, discoveries, patents, intellectual property, trademarks, and other IP from the individual title and ownership of the founders conveyed to the business or startup.
So when founders began working with each other, they then continue to own all of their intellectual property individually, and not as an asset of the business. This can create major problems if there is collaboration between the parties on the development of the underlying IP to the business, as it becomes unclear who owns what. If the founders the later cannot get along, and each of them want to move ahead with the project separately, disputes and contention can arise over who has the right to do so, and who held the underlying intellectual property to the project being developed. The proper conveyance of IP rights in startup projects and developments, which occurs so frequently it is referred to as the “Zuckerberg problem,” can be avoided with the proper handling in a founders agreement.
Buy-outs When Founders Can’t Get Along
What happens when founders can’t get along with each other? In some cases, one founder no longer wants to work with the other founders, or one founders not pulling his or her weight, and the other founders feel it is unfair to continue on. One of the provisions that is missing in many founders agreements addresses what happens when the founders split, whether it is by ejecting one or more founders from the business, or whether the startup as a whole must dissolve because no one can get along.
In most incorporating documents, the provisions tend to be pretty unfavorable toward founders, usually set up so that the company can buy back the founders stock for basically nothing (i.e., par value), through what is called the company’s right of first refusal. This can lead to devastating consequences for a founder who was the principal engine behind the startup, and comes into a situation in which he/she is “outnumbered” by the other founders or others involved in the startup. Think of Steve Jobs in the 1980s – kicked out of his own company because he was outnumbered by the very people he trusted to help build Apple. This actually happens quite often. No founder wants to be ejected from the startup they created, but unless the founders agreement requires mandatory redemption at fair market value (including for intangibles such as sweat equity, unearned wages, etc.) then the original founder is basically out of luck. We have represented a number of originating founders that have gone through this situation, and it is universally a terrible experience and can leave the founder scarred, resentful, and angry. Again, more reasons to have a proper founders agreement that this is the real central issues, and not fluff.
Bad Investment Proposals
There is only one thing that is worse than not ever receiving any funding for a startup through Angel investors, investment groups, or others, which is receiving a proposal that is actually a horrible deal. The reality of many investment proposals is that they are largely unfavorable to the founders, they can leave the founders with little or no ownership or management, and in many cases, not offer very much money. But what happened the founders disagree on whether to take up a bad proposal? If 3 of the 4 founders simply want to get as much money as is possible, even though it the deal is a horrible deal, that requires them to basically close down the business, and one founder, who originated the startup concept to begin with, does not want to sell off the business and wants to keep developing it, it can result in a situation where due to the number of votes, the startup either dies in an undesirable exit, or the startup breaks up because the founders can’t get along and agree on what to do next. A properly prepared founders agreement will avoid these issues, and put into place specific provisions that will protect the founders from being pushed into bad investment proposals.
► Other Things to Consider
- Taxes. Taxes are the ugly scourge of the business world, and many times altogether forgotten when it comes to founding new emerging startups. However, you should ignore the tax ramifications of what you do for your startup and how it will affect you, because you will and evidently invest time and money were both into your new venture. Depending on how your new venture structured, and whether you bear those expenses individually, or are reimbursed for them, you could end up missing tax write offs that would reduce your overall tax liability. Unless you prefer paying the government money that you don’t have to.
- Loose Lips and Anticircumvention. In a busy startup ecosystem, everyone is looking for the next greatest venture. If you and your cofounders come up with an idea that truly is unique and poised for immense opportunity, it is incredibly important to ensure that every founder is committed to confidentiality, loyalty to the startup, and will not go and sell ideas or work with competitors when things get tough. Having a founders agreement with broad anticircumvention provisions will help protect your company from having its ideas raided and misappropriated.
- Non-Disparagement. We typically put non-disparagement provisions in founders agreement so that, in the event the founders part ways, each can protect the reputation by not being the subject of disparagement by the other, especially if there is soreness in the departure or the terms of the circumstances are not amicable.
► Top FAQs
Check out of the top FAQs we get from startup clients with respect to founders agreements.
Should we do our founders agreement before or after we incorporate the startup? Generally, this is done before the start of the incorporation as a C Corp. or LLC, depending on what you pick, but there’s no reason why the founders agreement could not be tailored to address the points it needs to after formation. We would just adjust the provisions in the document focus on what it needs to, post formation.
Should we use a term sheet or an actual Founders Agreement? Is it okay to use a term sheet or deal memo instead of a Founders Agreement? We do both, and I think it is okay to do either. It depends on how comprehensive the founders agreement is going to be. Typically, when we do founders agreements, the founders agreement itself covers the legal obligations and covenants of each party, but the actual specifics of the new startup that’s going to be set up will be in the term sheet, such as who is going to be contributing wide, the voting structure, the capitalization of the startup, etc. The reason to include these things at this stage is so that you don’t fight about them later on. In business and startup matters, the passage of time can change a founder’s attitude and how they feel about what is best for them going forward. When a founders agreement is formed, usually nothing is happened yet, and that is often the best time to agree to the basic points about how the business is to be run.
Should our founders agreement including arbitration provision? It depends. Arbitration provisions are typically good for companies that are large, the don’t want to be bothered with lawsuits by lesser leveraged parties. Arbitration is typically favor the better leveraged party, and they typically disfavor the lesser leveraged party. The reason for this is because arbitrations are quite expensive, and are often much harder to win at than a typical lawsuit. So for example your typical fortune 500 company, in its goods and services agreements, will almost always have an arbitration provision, because the person on the other side is often an individual person with no real leverage, and not the kind of funds or resources necessary to take on a big company. So, in the startup context, and arbitration provision would favor an investor, and would probably be unfavorable to a startup founders with meeting talent or time/labor instead of money. You’ll have to decide whether you would rather have a dispute between the founders resolved privately, for a fee, or in the public context, such as the courts, for no fee. Arbitrations are a private version of the court system. The court system is funded by taxpayer money. Arbitrations are held by each party paying for them to happen.
We are being asked to identify who the “tax matters” partner is in our startup founding agreement. What is this mean and do we need to do this? Yes, this is actually normal. The IRS now requires new businesses, including new LLCs, to identify the point of contact with taxing authorities so that they have a point person to contact if there any questions about taxes. The tax matters partner is the person who is designated to do this. It would be normal to include this in a founders agreement. This will ultimately make its way into the initial resolutions of the C Corp., or the operating agreement of the LLC, depending on what type of entity is formed.
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