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Key Considerations in Founders’ Agreement

Updated: Apr 17

A founders’ agreement is a contract that lays out the rights, responsibilities, liabilities, and obligations of the founders of the company. The founders' agreement protects each founder’s interests and ensures that all founders agree upon the basic structure of the company before its incorporation. The agreement is signed either simultaneously with the incorporation process or before it. In addition, the agreement can be made legally enforceable by printing it on a non-judicial stamp paper, duly signed by the concerned parties with the appropriate stamp duty varying in different states.

Necessity of a formal Agreement :-

  1. A founders’ agreement can help in aligning expectations and mitigating conflicts amongst co-founders. It can provide a roadmap that formalizes roles and responsibilities, stipulates rights, and sets long-term expectations. .

  2. A written agreement can lead to the enhancement of communication over time. The agreement can be drafted in straightforward language delineating the roles and expectations of each founder, revisited periodically and adjusted as required.

  3. A founders’ agreement can establish processes to help in resolving future contentious issues and can improve decision-making.

Therefore, formalizing the agreement can improve communications significantly, provide a sense of stability and make uncomfortable situations easier to navigate.

Key Terms of the Agreement :-

It is necessary for the founders’ agreement to cover the following terms:

1. Ownership Structure:

The most important term of the agreement, as each founder brings their skill set, experience, and expertise to the table, and the ownership structure determines the proportion of equity ownership of the founders. This structure is determined based on various factors such as the monetary investment including how much money is being invested and at what stage, experience, existing intellectual property, know-how, network in the industry, and credibility. This ownership structure is necessary to ascertain the voting rights that the co-founders may exercise in the company.

2. Vesting:

It is necessary to provide a mechanism to deal with a situation where a co-founder exits or is ousted from the company. Therefore, the agreement should incorporate a vesting structure, discussing how the shares will be distributed amongst the founders in such a situation. This term should include whether the vesting will be on a time basis or milestones basis.

If the vesting of shares is time-based, then the shares owned by the founder shall be vested in proportion to the time spent by the founder in the company. If the founder decides to quit the company before the expiry of his term, then his remaining shares shall be returned to the company. The agreement shall state a time post which the vesting of shares shall begin. If the vesting of shares is milestone-based, the company must achieve the milestones set out in the agreement for the vesting of shares to occur. This process rewards the performance of the business as a whole. If the founder leaves the company before the milestones are achieved, the shares earmarked for such founder are not vested in him.

3. Roles and Responsibilities:

The agreement should outline the roles and responsibilities of each co-founder of the company. The founders may choose the title that best describes their role and responsibility, and these business divisions may include operations, technology, sales and marketing, finance, etc. In addition, the level of accountability for each founder, board composition, veto rights and deadlock resolution is fixed under this term.

4. Transfer of Shares:

The agreement shall provide for a lock-in period prescribing the number of years before which the co-founder does not have the permission to transfer his shares in the company. Further, a mechanism must be set in place to deal with a situation where the co-founder wants to exit the company before the expiry of the lock-in period. Furthermore, it is necessary to establish a method of valuation of the shares and the anti-dilution rights attached to the shares.

The shareholders should be given the right of first refusal under the agreement; to ensure that the equity of the company is not transferred to outsiders. The right of first refusal will require the founders to transfer their shares to outsiders, provided the same has been refused to be taken up by the other shareholders of the company. In addition, the company may impose further restrictions on the transfer of shares, including setting a lock-in period.

5.Intellectual Property Assignment:

The valuation of the company is affected by the intellectual property owned by it. The agreement must include a term that ensures the intellectual property rights of the co-founders are transferred to the company after the incorporation of the company. The company may obtain trademarks, patents, and domain names in the name of one or more of the co-founders and can be transferred to the company later. Furthermore, the intellectual property developed by the co-founders during their association with the company shall be owned by the company. Under certain circumstances, if the founder develops intellectual property, it can be shared between the company and himself. Additionally, the valuation of the intellectual property must be done carefully before it is transferred.

6. Value Additions in the Company:

Value additions are in the form of bringing in intellectual property rights, technical know-how, marketing rights, or similar additions to the company. This term on value additions is necessary to create a clear understanding of its various aspects including, the nature, the monetary value, the time of making the additions, and the related compensation to be paid to the co-founders. The co-founders may be issued shares against the value additions made by them; the agreement lays down its specifications, including the number of shares to be issued, percentage shareholding, and the method of valuation of such shares, to ensure there is no ambiguity about the same.

7. Non- Compete and Confidentiality:

The founders of the company are to refrain from engaging in any business that conflicts with the company's business. The agreement should clearly state the same, prohibiting co-founders from engaging in activities that conflict with the company's objectives during their association and for a period of a certain number of years after the termination of the agreement.

The founders know a lot of confidential information about the company, which may include trade secrets. The agreement should restrict the founders from disclosing any confidential information obtained during his/their association with the company, as the same may cause irreparable damage to the company's business. The agreement must also clarify what constitutes confidential information of the company, the duration for which the confidentiality obligations will continue after the agreement expires, and whether the company shall sign a separate non-disclosure agreement with the founders.

8. Terms of Employment:

The terms of employment of the co-founders must be clear amongst them, including designation, roles and responsibilities, compensation, benefits to be paid, and mechanism for termination of employment contract. The agreement may contain an overview of the same, and a separate employment contract shall cover the detailed terms of employment of the co-founders. The employment contract of the co-founder shall also contain a non-compete clause that prohibits the co-founder from soliciting clients or employees of the company to other entities post his departure from the company.

9. Contribution for Future Financing:

The agreement should contain detailed provisions for the contribution of additional finances by the co-founders towards the company's growth. There should be a clear understanding regarding whether such finances may be contributed as equity or as debt, the method of valuation of the equity in case the financing is through equity, and the rate of interest to be paid by the company in case the financing is debt financing.

10. Decision Making:

The agreement shall clearly state the manner of exercise of simple as well as substantial decisions. The establishment of such a structure shall improve the day-to-day functioning of the company. Further, the agreement shall determine the outline for the board of directors of the company. Subsequently, the board can appoint the chief executive officer of the company and allocate day-to-day decision-making tasks. In addition, the agreement shall provide the procedure to be followed by the company in case of a deadlock in decision-making.

11. Termination and Dispute Resolution Mechanism:

The agreement shall lay down the rights of the company as well the co-founders to terminate the agreement. The agreement may be terminated for cause or without any cause by a party or by mutual consent of the parties. Further, the agreement shall provide a mechanism for dispute resolution between the company and the co-founders concerning any matter stated in the agreement; this mechanism involves mediation, conciliation, and arbitration. The parties shall agree upon the governing law of the agreement, and the exclusive jurisdiction of the courts, to which the disputes under the agreement may be referred.

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