Founder Series Part III: How to Structure and Document Your Founder Agreement

You should never start a venture without thinking about how to end it.  Many founders make the mistake at the company's formation of slicing up the founders pie, serving everybody a piece, and treating that as the end.  In this case, it needs to be the beginning.  Here's why and what you need to do to protect yourself. Now that you have carved up the equity, you need to decide what to do with it.  Even though on day one your team is in place, your roles are assigned, and you are ready to develop your company, remember that the only constant is that the situation will change.  You will hit some roadblocks with your business plan and have to evolve your concept.  You will have to prepare for those events that you don't expect.  And you may even have to adjust your founder team by adding or removing members.  Keeping your structure flexible will prevent headaches (and money!) down the road.

First, you should have a agreement among the founders (and write it down!) to deal with these issues.  Use the structure up front to prevent disputes later.  And, as I have noted before, you have to deal with both the economic issues and the management matters.

  1. Equity Split and Ownership.  The discussion in the previous posts should give you a sense of why this is important to make clear up front, so I won't rehash that discussion.  But an important point in the Founder Agreement is to avoid using percentages to describe a founder's ownership.  Even though we often speak of percentages (as I am doing here for the most part) as a type of shorthand, the agreement should use specific numbers of shares of stock to avoid both legal and financial impacts down the line.  For example, if each of three founders has one-third of the company in the agreement, what happens when an investor is brought in or an employee is granted equity?  They need to be diluted to a certain extent to allow for the new stockholder.  This becomes even more important when someone leaves the company.  I once saw an owner claim an absolute right to keep 10% of a company because that was how it was stated in the agreement.  That will become unsustainable as your company grows.
  2. Vesting and Restricted Stock.  Remember that once you issue stock to a founder, it belongs to them and your options become limited if you want it back.  So vesting of the stock (giving the founders full ownership rights to their shares over time) becomes a valuable tool.  If three founders split the company in thirds and then, after six months, one of them leaves the company, their ongoing ownership should reflect that.  This is often done through "restricted stock", by which the company issues stock to the founders in accordance with the splits they devised, but that stock includes a right for the company to repurchase some or all of it at a very low price should that founder leave the company (for whatever reason) - a right that will slowly lapse over time.  Typically, that is done over a three- to four-year period (anything more does not really make sense for a startup), and can also include some acceleration up front or upon certain events.  Now if that founder leaves the company, she can keep what she earned in the time she was there, but the company can buy back whatever has not vested.  This leaves the other founders with a stake in the company that will better reflect their ongoing contributions. PLEASE NOTE: A discussion on restricted stock is never complete without mentioning 83(b) elections.  I will leave the details to another post, but don't even think about taking restricted stock without considering the 83(b) election because 30 days after the stock grant, you lose the option and it may cost you thousands of dollars in taxes in the future.
  3. Limits on Stock Transfers.  Founders choose to start a venture together because they bring unique qualities or because they have other relationship ties.  So you will likely want to have place some restrictions on when the founders can sell their shares (and thereby giving some or all of their rights to someone else) and to whom.  You could do it with an absolute ban on transfers without the consent of the other founders. But you can achieve more flexibility by adding a "right of first refusal" for the company or the other founders to buy the shares on the same terms, or a "tag along right" to give the other founders the right to sell some of their shares on the same terms.  A sticker situation develops when a founder dies or develops a disability that prevents participation in the company.  Since stock in a company is a personal asset, those shares will pass on death through a founder's estate.  So you may now be in business with that founder's spouse, kids, or someone else.  Consider including a buy-back provision at some predetermined price or calculation, or some other mechanism for transferring the shares.  Also, if you have a repurchase provision upon a "disability", you must take great care in determining exactly when that provision is triggered.  But in either a death or disability, it is wise to consider how you will fund the repurchase by the company or the cross-purchase by the other founders, which is typically done with proceeds from life insurance policies on the lives of the founders.
  4. Management.  Generally, the ultimate control of the company rests with the stockholders through the Board of Directors and is tied to their ownership percentages.  However, a company with founders shares split up evenly is ripe for deadlock and disputes.  Founder agreements often address this with provisions dealing with how to elect directors, who should sit on the Board, and how will voting happen.  Do each of the founders get Board seats?  If not, then who?  What about independent directors?  Beyond the Board, agreements will also often include overriding provisions for certain events and decisions.  Even if the Board has the power to determine most of the daily issues of the company, all of the stockholders together may want to retain control if the company is issuing new stock, taking on debt, making capital purchases, and other major events.  These issues may be particularly relevant to founders with less equity than the others.  These "minority interests" may need extra protection because they will have little control on their own.
  5. Intellectual Property.  Many startups have few assets more valuable than their intellectual property - whether it's comprised of software, patents, trademarks, designs, formulas, etc.  Having each founder contribute to the company any intellectual property she may have developed prior to formation is critical, but keeping control of the intellectual property that is developed over time can also prevent problems in the future.  I once saw a company's public offering fall apart when they determined that the intellectual property that served as the basis for the company's value was not properly owned by the company.  So sloppiness in this area can have profound effects.  The founders can also decide in this agreement what should happen with the intellectual property if the company is dissolved.  Even though the business may have failed, the intellectual property can be very valuable going forward.

The bottom line is that founders need to spend some quality time working through these issues.  As I mentioned in the previous post, the process can be quite uncomfortable with founders focusing on what happens when things go wrong.  However, nothing will ever go as originally planned, and it will be much easier and less costly to deal with these issues up front than when the dispute arises later.

Read more about founders in my Founders Series Part I and Part II.