Starting up? Have you considered a Co-Founders’ Agreement?
Updated: Sep 29, 2021
Summary of webinar held on September 22, 2021 in association with 91Springboard
Setting up a company is a complex task considering the endless statutory requirements, missions, vision, systems and other small intricacies that take time, effort, and money. While these bigger ideas are being executed, one of the most ignored aspects while starting out, is a Co-Founders’ Agreement. While it is not a statutory necessity, a Co-Founders’ Agreement is entered into between promoters/founders (used interchangeably) and co-founders. An important point to keep in mind is that this does not include key hires, employees or CXOs. A question that often pops is why should this agreement exist when it is not statutorily mandated? Let's take a simple use case: You start a company with your best friend. You set up the company, and you both have 50% stake. One day your best friend decides he wants to leave because the stress is getting to him. There’s a small plot twist. Your best friend has 50% of the stake but he does not want to give it up. He says, “I know I invested only Rs. 50,000 but if you want the shares back, pay me Rs. 5,00,000”. You are awestruck but there’s no legal recourse. It comes down to mere negotiation. In an even worse turn of events, your best friend threatens to sell this stake along with Intellectual Property to a competitor. Fortunately, a Co-Founders’ Agreement can save you from this very unfortunate situation. The agreement contains clauses that cater to mishaps and, in consequence, levy penalties that are mutually agreed by the parties. To set this agreement in stone, printing it on paper can be beneficial to both parties without the requirement of a notary or registration. A common flaw is that parties tend to create this agreement just before an investor enters the equation. The entry of an investor gives rise to the existence of a shareholders’ agreement which is essentially another type of the same agreement. Hence, the requirement of a Co-Founders’ Agreement becomes redundant. A good time to negotiate the Co-Founders’ Agreement is when the idea of starting up sprouts which means the sooner, the better. The key terms of this agreement should be mutually agreed and negotiated. Broadly speaking, the key terms of a Co-Founders’ Agreement are as follows, but the details will vary depending on the mutual agreement between the parties:-
Shareholding Structure: Details of timelines of contribution, vesting schedules, who is bring in what - cash or sweat? Vesting schedules are of particular importance as they define the timeline of how the shares will be released or unlocked overtime.
Control/Corporate Governance: Details regarding the roles and responsibilities of members, the composition of the board, resolution in case of a deadlock and veto rights are part of this term.
Hire/Fire/Retire: Terms of lock-in of shares and employment, early exit of any party in case of moral turpitude/ embezzlement, cases of non-performance and clawback/ reverse vesting are points of discussion in a Co-Founders’ Agreement. Another important aspect to include is the consequence of breaching a lock-in. In case of fraud or embezzlement, the consequence is that shares are sold by the defaulter to the other founders/ ESOPs at par value (and this is usually the case even for resignation during the lock-in period which constitutes a breach of lock-in). However, these can vary as per the terms of the contact.
Transferability of Shares: When shares are no longer locked in, they cannot be sold to the competitor at any cost. Exit rights must also be clearly defined in the agreement in case of any mishap and who has the authority to decide when the clause must be executed.
Other provisions: Terms such as non-compete, non-solicitation, defaults and indemnity must be mutually set out by parties in the agreement to avoid any disagreements between the parties.
A Co-Founders’ Agreement might be a difficult conversation to have, especially when promoters or founders are close to begin with, but awkward conversations are important especially when money is involved. Agreements such as these always set out clear terms in case of disagreements or disputes and thus, having a document to rely on sets out the rights of both parties clearly. The key terms must be mutually discussed while setting up the company in order to avoid complications and having the agreement printed and stored is a great way to set it in stone.
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