In our previous blogpost “Three legal “to-dos” as you begin your entrepreneurial journey” we touched upon the importance of a founders’ agreement. Here, we briefly discuss the basics of a pre-incorporation founders’ agreement.
A founders’ agreement is a contract between co-owners of a business that outlines each of their roles and responsibilities, ownership interests, and rights in the business. It may be a standalone document or may be incorporated into a shareholders’ agreement, a partnership agreement, or an LLC agreement. In this piece, we focus on pre-incorporation founders’ agreement—the first document we recommend be put together just as soon as two or more persons get into business together as co-owners. This will help protect the interests of each co-owner and avoid any potential disputes among them later.
So, what should founders include in a pre-incorporation founders’ agreement? Although the answer will vary depending on the line of business, a typical pre-incorporation founders’ agreement includes these items:
- Name of the parties and (potential) name of the business: The agreement should identify each party that will be bound by it. If the founders already have a name lined up for their business that should also be included in this agreement.
- Goals of the business: As your business grows, its goals will evolve. However, stating the business’s goals in the founders’ agreement helps founders align their vision and objectives not only relating to the offerings of the business but its culture, growth strategy, and road map for future.
- Roles and responsibilities of each co-owner: A founders’ agreement should include a provision describing the roles, responsibilities, and authority of each co-owner of the business and what each is expected to accomplish. Recording your understanding of each founder’s role helps delineate decision making responsibilities on various matters, increases efficiency, and reduces the likelihood of potential disputes regarding decision-making authority.
- Contributions: What are each founder’s contributions? Labor or capital? If founders are contributing capital to the yet-to-be-formed business, will those contributions be loans to the business or contributions towards equity? To avoid any disagreement on these items, the founders’ agreement should include a provision describing contributions by each founder, and if capital contributions are being made, whether those will be loans to the business or contributions towards equity. (We will discuss how founders should contribute capital to the business in another blogpost).
- Equity ownership and vesting: Not all co-owners will contribute equally to the business, whether they are contributing capital or time. Hence, not all co-owners share equal ownership in the business. Many disputes among founders relate to their disagreement regarding shares in the business. To avoid this, address and agree on ownership stake right at the beginning. If founders are contributing labor for future equity, we recommend tying vesting of equity ownership to a schedule based on time periods or milestones. This ensures no founder walks away with equity without earning it (for more on stock vesting, review DLA Piper’s “Founder’s Stock Vesting”).
- Voting structure: In the pre-incorporation stage, it is easy to ignore this important issue. We recommend addressing upfront if voting will be based on one vote per owner or divided up among co-owners based on their agreed upon ownership stake in the business — for example, the holder of 76% ownership stake will have 76 votes.
- Intellectual property ownership: When founders work together to create a product, unless they have specifically assigned ownership of it to the business, each may be free to walk away with all the ideas related to the product and start a competing business. Therefore, ownership of intellectual property is an important item to include in the founders’ agreement. This provision should identify clearly what constitutes intellectual property of the business and include an assignment of intellectual property created by each founder (whether alone or jointly with others) during his or her relationship with the business to the business.
- Confidentiality obligations: To avoid a departing founder from using or disclosing confidential information of the business, a founders’ agreement should include a provision regarding confidentiality obligations that forbids any founder from disclosing or misappropriating the business’s confidential information either during or after his or her relationship with the business has ended (carve-outs for legally mandated disclosures or agreed-upon exceptions can also be included). In today’s competitive startup space, it is vital to a new business’s survival that its unique ideas and creations are protected through a commitment to confidentiality by each founder.
- Duration and exit: A pre-incorporation founders’ agreement should have a validity period to ensure founders are not tied to work indefinitely in the business without a clear goal post of when the business’s status will be evaluated to determine whether it should be terminated (for example, because the business has failed) or continued. Also, we recommend addressing what happens if a founder wants to leave the business or has to be let go because of lack of contribution to the business—the so called “exit” scenarios.
- Dispute resolution: A robust dispute resolution procedure should also be built into the founders’ agreement to efficiently resolve any disputes or deadlocks among founders.
As we concluded in our earlier blogpost, it is an important foundational step to have a founders’ agreement. If hiring an attorney to help draft a pre-incorporation founders’ agreement is not within your budget, we recommend you draft it yourselves—there are many online templates to help you get started. Documenting your understanding on the items above from the get-go will not only help reduce potential disputes but also increase economic efficiency by aligning goals and expectations.