As an entrepreneur or a startup founder, if there is only one agreement you can ask from a corporate lawyer for your company, what will that agreement be?
After being involved as a corporate lawyer for over a decade on a wide range of legal work for bootstrapped startups to venture-backed companies, I believe there is one single most crucial agreement that every business owner, entrepreneur, and the founder should have is an agreement covering the following items below.
These agreements are usually known as a shareholders agreement, stockholder agreement, founders agreement, and also known as a partnership agreement in some places. Although they may be called by different names, entrepreneurs and founders should ensure that they cover the following issues in such an agreement.
By default, if you don’t have a shareholders agreement in place between the shareholders (at the initial early stage of a company, usually only between cofounders), the “fallback” positions for the commercial terms will be based on the existing companies laws. In other words, the default positions under the statutes covering such issues that may or may not be in your favour.
If you don’t have this agreement in place addressing these commercial issues below, you may likely get into a dispute that may you up in a courtroom (that means expensive long legal battle!).
In my experience, I have seen entrepreneurs losing their business because they failed to put any agreement in place. I also know founders like to ignore the importance of discussing these important issues for the sake of trying to avoiding a ‘difficult conversation’ with their team members.
If you don’t want to address these issues upfront before you start the business, you may end up getting into a major disagreement once you start running the company especially in stressful times like fundraising or even scaling a business. If you don’t want to have this difficult conversation for fear of upsetting the other founder, you may be doing yourself a favour and be better off by not starting a venture with the person.
The company may not be able to survive a deadlock when there is no way out in a shareholders’ dispute, especially when there is no agreement in place to resolve such conflict.
When drafting a shareholders agreement, make sure you work with a corporate lawyer to address and answer all these important questions.
Setting out and recording different contributions by the founders
Different founders bring in different expertise and skillset to a business. What are the specific contributions that will be made by the respective founders to the business? What if one founder puts in cash? But the other founder only provides his sales skills? How will each of these contributions get treated and be valued in monetary terms?
Putting up a fixed decision-making framework on business decisions
In practice, when there are only two founders, both founders tend to agree for their equity ownership to be owned equally 50/50 by the founders (personally, I do not recommend this). How will you both decide if there is a deadlock between both of the founders? In other words, both of you can’t agree on a matter and ended up with a tie vote?
Will the voting deadlock get fixed by a third party independent and trusted person (like a neutral friend) to come up with a final deciding vote? Or even trigger a buy/ sell agreement (usually known as a ‘shotgun agreement’) for a founder to acquire the shares by the other cofounder when both can’t agree on a decision), or mediation, arbitration, or another method?
Managing transition of key people in a business
What if an existing founder decides to leave the business after six months after starting a company with you because he decided to accept a different role or leave the country to start a new venture some place else? What will happen to the shares that have been issued upfront to the outgoing founder (usually known as a vesting schedule)?
Will it get forfeited or can it be retained by the outgoing founder? And how will the business handle the departing founder’s exit and his equity interest? And how will the business onboard a new founder?
Clarity on ownership of intellectual property assets
What if a founder develops a new software? Will the founder be required to assign the ownership of the software to the company? How will the founders decide what type of intellectual property assets needs to be assigned to the company? Can a founder merely license out the platform to the company for a fee?
Minority shareholders protection
What if one of the cofounders only has 30 percent equity ownership in the company? Or an angel investor that came on board in your company at the pre-seed stage only has a 5 percent stake? What are the safeguards in place to ensure that both of them are protected against critical business decisions as a minority shareholder?
Some of the usual critical business decisions include:
- deciding on the salaries of the staff
- hiring new staff or firing of existing staff
- buying new assets or selling assets owned by the company
- changing the business direction
- agreeing on a budget
- onboarding new founders
- taking up loans or issuing loans
- getting the founders to put in additional capital contributions (also known as a ‘capital call’)
- entering into a contract or terminating an existing contract
- investing in other new ventures
- winding up i.e. closing down a business
Board composition and appointment mechanism
How will you decide who gets to be a member of the board of directors? How will the board member be elected? Will certain founders have a right to be on the board or to appoint a number of directors? How will a director get removed from a board seat? Only for certain grounds or for any reason? How will vacancies on the board get filled?
If the board of directors decides to set up new committees like an advisory committee, how will the members of these committees get selected, removed, and replaced?
Are the founders of the business bound by confidentiality obligations? What amounts to “confidential information” in a business? What type of safeguards in place to protect the business from the cofounders disclosing proprietary information?
Are the founders of the business required to dedicate their time exclusively to the business? Or are the founders agree not to undertake any other similar venture that may be in competition with the business?
Funding options for the business
What if the company’s cash runway is depleting in several months? What will be the first preferred mode of funding? Will it be equity funding or debt funding? What if one of the founders fails to contribute to the capital call?
Profits distribution mechanism
Let’s say the business makes profits which allows the company to issue out dividends (i.e. the distribution of the company’s earnings to its shareholders). How will the founders decide how much the company’s dividends will be? Will it be agreed upfront or based on a certain threshold? And how often?
Managing expectations and performance issues
If a founder fails to fulfill his obligations to the company like failing to achieve certain business milestones or deliverables, will the founder be compelled to sell his shares? If so, how is the value of the equity interest will be assessed and determined by the founders? Will the founders agree on an upfront formula?
Or engage a third party valuer (like one of the Big Fours accounting firms)? Or a combination of the two? Also, which party will be responsible to pay for the fees and charges in relation to the equity transfer? Will the final purchase price for the equity be paid in a lump sum? Or can it be paid over a certain timeline?
Restrictions on transfer and disposal of shares
What are the restrictions and conditions in place if a founder wants to transfer his shares in the company? Can the founder transfer the shares to anyone like a competitor, an enemy, an ex-girlfriend, or anyone that may not be beneficial to the company? Will the existing founders or shareholders have the right to match any offer received by another potential buyer seeking to sell his equity interest?
Dispute resolution between shareholders
What if there is a dispute among the cofounders? How will the shareholders resolve their dispute between themselves? Will it be resolved by a judge in a normal court? Mediation? Arbitration?
Dealing with these commercial terms can be overwhelming for many new aspiring entrepreneurs or founders. But look at having a shareholders agreement as a statement or a record of your understanding between your cofounders.
So if there is any dispute, any founder can refer back to their shareholders’ agreement to find out what was the initial agreement in terms of the relevant roles and responsibilities agreed by the cofounders and even the investors in a company.