Understanding the Importance of a Founders’ Agreement
Many businesses tend to start off as an idea between family and friends and while the business will have been started will good intentions, but sometimes relationships can breakdown for one reason or another causing friction which can affect the business. When considering starting a new business venture with others, the significance of a well drafted founders’ agreement cannot be overstated.
While not a legal requirement, this crucial document establishes the foundation of the relationship between the founding members and paves the way a clear strategy of running the company from the offset . It also ensures that all the founders are all aligned with the vision for the business.
In this article, we will explore:
What is a founders agreement?
Why is a founders agreement important?
What key elements should a founders’ agreement include?
What is a Founders Agreement?
A founders agreement is a legal document that outlines the rights, responsibilities, and obligations of the founding members of a company. It is the contract that governs how the founders will work together, how the founders will make decisions collectively, how to handle any disputes that arise, and how to navigate various scenarios such as the exit of a founder or the sale of the company.
A founders agreement should provide clarity on how the transaction is to be managed and it should ensure the interests of the founders are protected.
Why is a Founders Agreement Important?
Decision-Making Clarity: A founders agreement shapes the process of key decision making. It outlines voting rights and procedures and ensures decisions are made efficiently and in a controlled manner.
Protection of Rights: A founders’ agreement protects the rights of each founder.
Conflict Resolution: A well drafted founders’ agreement will contain mechanisms for resolving disputes, therefore ensuring any disagreements among the founders are handled amicably and without disruption to the M&A process.
Exit Strategy: The founders agreement should outline the terms of what would happen to the business and any underlying assets should a founder leave the company. This will ensure the departure of a founder does not adversely affect the ongoing operations of the company. It should also set out what would happen in the event the idea or the business is abandoned.
Key Elements of a Founders Agreement in M&A Transactions
Roles and Responsibilities: The founders agreement should clearly define the roles and responsibilities of each founder.
Contribution and commitment: The founders agreement should set out what each founder brings to the business and how it is to be recognised, whether as a salary or in terms of equity.
Equity and Ownership: Following on from above, equity ownership and vesting are fundamental components of a Founders Agreement, specifically relating to establishing the stakes and commitment levels of each founder in the company. The allocation of shares will detail the specific ownership percentages for each founder within the Company. To ensure long-term commitment and protect the company’s interests, vesting schedules can be implemented, outlining the conditions under which founders earn their equity over time. Vesting schedules can span several years in which equity can accrue, subject to continuous employment or specific performance milestones.
Decision-Making Process: A founders agreement will govern the decision making process by making clear the roles and responsibilities of each founder, outlining their decision making authority, specific voting rights and methods for reaching decisions. This may also include procedures for electing new board members and how their decisions will be taken into account. Additionally, it provides for how the agreement can be amended, ensuring any changes are agreed upon by all founders, thereby promoting fairness, transparency, and alignment among the founders.
Dispute Resolution: Dispute resolution is a critical element in a Founders Agreement, providing a structured approach to handle conflicts that may arise between founders. It will typically outline the various conflict resolution methods that may be used as an when disputes arise. The agreement will specify the governing law and identify the jurisdiction and legal framework under which the agreement can be interpreted and enforced.
Confidentiality and Non-Compete Clauses: Throughout their tenure, founders will have access to a significant amount of confidential information of the company, including know-how, IP and trade secrets. Including provisions that prohibit a founder from disclosing such confidential information and from participating in activities that conflict and compete with the company’s objectives during their tenure and for a limited period following the termination of the agreement will add value to the company’s transaction and mitigate commercial and competitive risks.
Terms of Employment: The terms of employment for the co-founders must (1) meet the legal requirements and (2) clearly set out the legitimate business interest of the company which are to be protected. Whilst a separate employment contract will cover this, the founder agreement should provide an overview of these terms.
Exit Provisions: The exit strategy and conditions section of a Founders Agreement is crucial for defining the processes and terms when a founder exits the company. This includes termination clauses that specify the circumstances and conditions under which a founders can be removed or choose to exit the company. These clauses might encompass voluntary resignation, dismissal for cause, or other specific scenarios such as a breach of the founders agreement or failure to meet performance expectations.
Additionally, provisions setting out details around what would happen to a departing founder's shares would be set out in the agreement. These terms often include the valuation method for determining the price of the shares, payment terms, and any conditions or restrictions on the buyout process.
Conclusion
A well-drafted founders agreement is essential in ensuring the smooth running of the company. As explained above, it establishes a structured framework for founder interactions, decision making and conflict resolution.
By addressing potential critical issues at the outset, a founders agreement can minimise the risk of disputes and matters proceeds seamlessly and successfully.
If you are a founder looking to set up a new venture, or have recently started a new venture, with new business partners , investing time and resources into drafting a founders agreement is a critical and strategic step to take and may you from a painstaking and expensive process if things do not work out the way you had all hoped.
Contact Yao Trinh (Head of Corporate and Commercial) and/or Cacy Neilson (Head of Legal Operations and Employment) for further information on preparation of a Founder Agreement.