Before writing this article, I spoke with three lawyers who…
(How to avoid co-founder disputes in a startup – Part 2)
“We restructured our Founders’ Agreement three times over a period of three years, and the third time, the restructuring was with the help of a lawyer,” said a founder whom I interviewed. This clearly shows that having a standard Founders’ Agreement is not enough to protect your business. It is more important to have an agreement tailored for you and your business in such a way that it covers in specific and not generic terms most aspects that might possibly lead to disputes between the founders. It should be comprehensive yet not complex. There are numerous templates of Founders’ Agreement available online, and it is fine if you would want to use one of them provided you customize it to the situation of your startup. In my previous article on How to avoid co founder disputes, I mentioned the relevance of having a Founders’ Agreement and also touched upon clauses such as vesting period and cliff period in an agreement.
A suitable Founders’ Agreement is crucial to your business growth and definitely should not be taken lightly. When you are stating factors such as roles and responsibilities, non-disclosure, exit of the cofounders, termination etc in an agreement, you must know that none of these provisions are standard to any business. Roma Priya, a Delhi-based lawyer and founder of Burgeon Bizsupport says,
“There is no rule which says that cofounders should have an equal equity split. Similarly, there is no definition of a vesting period in the number of years.”
In this article, I will consider some special cases and questions which entrepreneurs often miss addressing while signing a Founders’ Agreement.
One co-founder gets in the money and other invests time
This is one of the most common scenarios: one co-founder has a full-time job other than the startup but has capital to invest in the business, the other co-founder compensates by giving in full time to the business. Fernando Torales Chorne, co-founder, POD Health says, “ Time is one of the most important assets for a young company. When we started up, our biggest challenge was that all the cofounders were not spending enough time in the business. We had to later restructure the Founders’ Agreement in which time was given a lot of weightage.”
Anirudh Rastogi, Managing Partner, TRA, a Delhi based law-firm says that an equity split depends on a number of factors in such a scenario. “How much money is being invested and at what stage in the life cycle of the company? Does the partner (who in effect is really acting as an investor in this scenario) also bring other intangibles along with the money, such as industry connects and credibility? Does the active partner bring in several years of experience?” One must bear in mind that subsequent investors would appreciate that the active partner has a significant stake in the company so as to constitute a serious skin in the game; and also that the active partner has enough equity for future dilution in subsequent investment rounds. “Usually, I would not recommend active partners diluting beyond say 30 percent in the first round, but my answer may differ if the partner/investor is putting in an extraordinarily large sum of money for the nature and size of business and also at the stage of the business the money is contributed,” he says.
How to split equity when one co-founder joins at a later stage?
Appachu SK, Chief Operating Officer, WorldArtCommunity.com says, “It is relatively straight forward when co-founders start the business together at the same. They would divide everything from equity to responsibilities depending upon what each party brings to the table. It gets more complicated when one of them joins after the wheels of the business are already in motion. Naturally this needs to be factored in as well, adding to the intricacy in the agreement.”
There are some other things to be kept in mind when you have such a scenario: Is the person coming in late bringing several years of experience over the other founder, a lot of credibility and relevant industry connects, and it seems that this business cannot run unless this new founder is brought on board? It needs to be evaluated on a case by case basis. Anisha Patnaik, co-founder of LexStart explains, “For example, a co-founder joining within two months of a company having started will have a significantly higher stake than a co-founder who joins 12 months after the company has started operations.”
Be careful with designations
Not every partner in your business needs to be a co-founder. Be cautious in giving that tag. Cofounders should ideally not exceed more than three.
Jitender Tanikella, partner at TRA says, “It is not just about equity. The founder tag also has a great market and representational value of the company. “Often times, early stage companies make the mistake of assigning the designation of founder to friends, mentors, consultants who help them at this stage. While they certainly deserve the equity value of the services they rendered, naming them as cofounders may present a business and reputational risk for the startup itself.”
Keep aside some equity for future dispersion
For instance, if you are two cofounders, you necessarily do not need to divide 100 percent equity between yourselves at the very beginning. Founders often keep aside equity for employee stock options (ESOPs), also known as an “ESOP Pool”. Most sophisticated investors would require founders to set aside such a pool at the time of investment for future key employees. “We usually see a pool of between 7 to 15% equity. Anything more is too high. About 10% seems reasonable and is more or less the market standard,” says Anirudh.
If one founder brings in the IP with her….
It is usually a standard principle that the (Intellectual Property) IP must be assigned to the company; especially in a technology-led venture where the IP is the core asset of the company. If not, then the concern is what happens if the founder owning the IP were to exit the company or expire, or decide to transfer the IP to a third party. Jitender Tanikella from TRA is however clear on his stand on IP and tells that it is only fair that the founder who is expecting the agency of the company to monetize the IP should contribute the IP into the company. Simply put, a founder who is unwilling to assign the IP is not your right co-founder. That said, in very specialized high technology sectors the founder can consider sharing the IP jointly with the company. However, this needs to be well thought of and documented properly and is by nature limited to such sectors.
Do you need a lawyer/attorney while signing the Founders’ Agreement?
Most entrepreneurs I interviewed for this article did not have a lawyer when they signed a Founders’ Agreement, and a few of them said they regret not having one. Hence, yes you may sign this agreement without involving a lawyer, but you must carefully examine each clause and customize it well to your business. You will, however, need a lawyer when the company is slightly mature and has crossed the phase of early stage.
What to do when there is breach of contract?
A well thought out Founders’ Agreement can be extremely useful in amicable dispute resolution and in the worst case scenario, in seeking justice in a court of law. The guilty founder is bound to legal action and can be dragged to the court in the event of a breach. It is likely that when the time comes, you may evaluate the cost and benefits of litigation and decide against going to court. If the agreement is drafted comprehensively, then parties may often be able to resolve the dispute because the agreement provides a recourse for the situation they find themselves in. Such agreements are of most relevance to a country like India, where the court could take years to resolve a dispute.
Note: This article contains views of many entrepreneurs who wished not be quoted. The questions addressed are based on mistakes made by some entrepreneurs in their Founders’ agreement.