We are aware of the importance of the core team in building a startup from scratch. A strong core team is all the more important when the startup goes through the process of fundraising. While the idea and the business model are key, ultimately, it is the team that the investor is effectively investing in.
In several instances, we come across individual founders of tech startups, who do not come from a technical background, label their CTO, or a similarly placed employee as a co-founder. This is typically done to demonstrate to an investor the presence of a larger / specialized team. Is this okay? This could have an adverse effect at times. Why?
In order to comprehend this, we first need to understand investors’ expectations of a founder/co-founder/promoter (please refer to our first blog in the series for an understanding of founders/co-founders/promoters: https://www.lexstart.com/post/the-basics-of-a-co-founders-agreement).
• The founder is effectively in charge of running the show. Anything goes wrong, it is their neck on the line!
• The founder, in addition to securing his/her own interests, is answerable to the investors for everything, like (i) ensuring that the company is run efficiently and the business projections are met, (ii) ensuring no employee/consultant commits fraud, (iii) company policies are implemented and adhered to, (iv) company remains solvent, (v) providing the investors with a suitable exit and the list goes on! Any default of such responsibilities (or covenants as they are called in an agreement) will lead to the investor exercising its right to trigger an Event of Default!
What happens in case of an Event of Default? Well, this depends from investor to investor, but the consequences can vary from (a) taking over control of the Board of Directors of the startup, which would effectively mean removing the founder/s from the Board, (b) right to an accelerated exit, i.e., requiring the startup and founder to find avenues to enable the investor to sell its shares, which can also include a buyback of the investor shares by the startup or even forcing a full sale of the startup, which implies that the investor has the right to exit the company by selling to a buyer their own shares and additionally the shares of the founders/co-founders /promoters if the buyer so requires.
These are immense responsibilities to bear as a co-founder and one needs to ensure that their CTO is up for the task before you grant them the “co-founder” tag, so as to not leave him/her overwhelmed. Another critical aspect to consider before granting someone a “co-founder” tag is the repercussions in case the person decides to quit midway.
Typically, in addition to the responsibilities discussed above, an investor enforces a lock-in on the founders (and not on employees). Like we mentioned earlier, investors invest in the founders/founding team of the startup; hence, from the investors’ perspective  it is important that the team continues to be in the employment of the startup for as long as the investor is in the startup!
Despite the lock-in, if a founder decides to resign midway, then such founder may forfeit his/her right to its shares in the startup, and the investor may have the right to buy these shares at the lowest price possible. Such an exit may also trigger an Event of Default.
It is for the aforementioned reasons that one has to be careful in positioning key team members as co-founders.
Some pointers to keep in mind before granting someone the coveted “co-founder” tag:
1. Check how vested they are in the cause. They need to lead with an understanding that it is “their company”, “their startup”, “their business”, and not just your business that they are joining to lead a certain vertical or play a certain role.
They should be prepared to be in it for the long haul. Entrepreneurship is not for everyone, and if someone is just “giving it a shot”, then you rather have them as your employee in a CXO role, than as a co-founder.