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Founders’ Agreement and its Importance

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Founders’ Agreement and its Importance

July 16, 2021

In today’s world, it is quite frequent to observe likeminded individuals engaging into partnerships in every spectrum of the business sector. Gradually, most of these partnership converts into a company with an aim to diversify and in order to expand the size of the business. Alternatively, many individuals also prefer to directly incorporate a startup for conducting their business, rather than forming a partnership at initial stage. With the growing trend of technology, competition in market, and aim to develop a better lifestyle, the younger generation has demonstrated diverse form of doing business, thus, leading to formation of new set of prototypes for building unique structure of companies in comparison to the traditional ones. Keeping all other factors aside, these new generation companies have one common and definite goal in mind – to make profit through innovative thinking.

Need for a Founders’ Agreement

The upcoming startup/companies are not identical to the age-old traditional companies; rather these can be more specifically described as the brainchild of youngsters who intend to change the world through innovative thinking and efficient use of newly available resources. However, with the emergence of these innovative startups, it is pertinent to state that there has also been a comparative increase in the risk of loss of money.

In the last decade, this has been observed in the famous co-founder dispute of ‘Housing.com’. The company was started by a group of 12 IIT Bombay alumni. Later on, the co-founders were known to dispute among themselves with regard to power struggle in the company, which eventually led to resignation of 9 out of 12 founding members of the Company over a period of time. The original co-founders were known to have no founders’ agreement in place, before starting the entity, the consequence of which resulted in such mishappening. As per various critic’s observation, a strong and comprehensive founder’s agreement could have safeguarded the member’s interest and may have averted the dispute that maligned the image of Housing.com and its co-founders. Another classic example pertaining to this matter would be the firing of Steve Jobs from his own Apple Inc. He was requested to quit the company pertaining to the differences between him and Steve Wozniak.

These instances cast a harsh spotlight on the pitfalls of incorporating a company and/or engaging into a startup. All innovative ideas written on scraps of paper or long brainstorming sessions seems to be in mortal peril when clearly defined understandings are not just in place between the members. Some of the most common causes that results into the breakdown of a company/startup includes capital insufficiency, low estimation of demand, low scale marketing standards, low focus and emphasis on the customers etc. What takes precedence is that such breakdown leads to creation of irreparable damage on the members as well as the company.

The best solution to avoid abovementioned issues is to have a founders’ agreement in place since the very inception. In layman terms, a founders’ agreement can be stated as a formal agreement which is executed by and amongst the co-founders pertaining to several key issues with regard to running the business of the company. This agreement helps in preventing and settling disputes arising out of differences amongst the founders of the company, by laying down provisions related to the roles and responsibilities of each founder, thus, establishing a robust system of management and dispute avoidance and settlement. It is advisable that such agreement shall be put in place prior to incorporating and/or conducting any new venture. The agreement indicates the governance model of the startup and plays a vital role in creating an impression on the investors as well.

Key components of a Founders’ Agreement

Founders’ agreement aim towards forming an open dialogue for the founders to air out their queries, understanding, demands and expectations with regard to several matters including (without limitation) management, operations, finance, dispute and possibility of peaceful dissolution of the company (if needed). In this regard, it is essential to draft a well-balanced agreement keeping in consideration and respecting the interest of all the parties to the agreement. Even though there will always be a Memorandum and Article of Association in order to govern the relationship between the stakeholders, however, such documents would mostly aim towards being the company’s bylaws and not determine relation between the founders.

Some of the most important clauses which should form a part of every founders’ agreement are as follows:

  1. Equity ownership

This can be considered as one of the most important provision in the founders’ agreement. The provision lays down the proportion of equity ownership for each of the co-founders, based on their capital contribution in the company. This includes the percentage or number of equity shares held by each founder or the percentage of initial contribution committed to be infused by each founder. Such determination shall be made pursuant to consideration of several factors including but not limited to monetary investment, inputs in term of intellectual property, experience and network in the market, technical and business know-how etc., of each founder.

In accordance with the vested equity ownership, each co-founder shall be assigned voting rights in the company. Hence, it is necessary to clear out such understanding at the initial stages in order to avoid any potential future conflicts among the founders.

  • Roles & Responsibilities

Under this provision, the roles and responsibilities of each co-founder shall be specifically demarcated (if possible) for the smooth conduct of business. If all the founders have similar and overlapping roles in the business, such would lead to chaos and inefficiency between the founders while conducting the business. Hence, it is advised that the parties, while drafting this provision, shall clearly demarcate and assign the roles and responsibilities to each founder pursuant to their area of expertise and skills. Generally, in a company, the roles and responsibilities of every founder is divided under marketing, operations, finance and administration. In this way, each founder shall be compelled to take ownership of the business and shall be held accountable for its conduct in the business.

Some of the essential to be included under this provision are as follows:

  • Vesting rights

A vesting structure shall be incorporated in the Founders’ Agreement which shall detail the manner in which shares shall be vested on each founder. This provision will act as a mechanism to deal with a situation where any of the co-founders exits or is ousted from the company for any reason whatsoever. Generally, it has been observed that the vesting of shares is conducted in one of the following manner:

  • Time Based Vesting: Under this mechanism, the shares are vested in accordance with the time spent by such founder in the company. Where such founder, for any reason, is ousted from the company or decides to exit the company before the expiry of his term (i.e., lock-in period), the remaining shares of such founder shall be returned to the company. Generally, a time period (also known as cliff period) is agreed within which the vesting of shares shall initiate. One of the major drawbacks in this mechanism is that the performance of the founder in completely neglected while vesting of shares.
  • Milestone Vesting: Under this mechanism, vesting of shares happens when the milestones set out in the Founders’ Agreement is achieved by the company and/or such founder as the case may be. Unlike time-based vesting, this mechanism focuses on the performance of the founder in the company. In this case, if the founder leaves the company prior to achievement of a particular milestone, the shares earmarked for such founder shall not vest in him and will be returned to the company.
  • Conduct of Business

Apart from the foregoing, it has been a general practice to lay down various provision related to manner of conducting of business under this provision. Some of the essentials to be provided under this provision shall include (without limitation) the following:-

  • Name of the founder(s) who shall be responsible for the day-to-day management of the company and compliances with applicable laws;
  • Undertaking by the founders that the board of directors shall have the sole discretion and decision-making pertaining to various aspect of business;
  • Undertaking by the founders that the business of the company shall be conducted in accordance with the business plan as approved by the board of directors;
  • Name of the founder(s) who shall be responsible for the maintenance of proper books and records of the affairs of the company in line with requirement under applicable law.
  • Confidentiality

The Founder’s Agreement may include a confidentiality clause wherein an obligation to protect sensitive business information shall be vested on the founders. Some parties may even choose to keep the content of founder’s agreement under confidentiality. However, this shall be solely determined pursuant to the understanding between the founders as well as the company.

  • Ownership of Intellectual Property Rights

It is quite frequently observed that the companies, at their initial stage, obtain various intellectual property (such as trademarks, patents and domain names) in the name of one or more of the co-founders initially which later is supposed to be transferred in the name of the company. Hence, it is advisable that the Founders’ Agreement shall under this provision state that the intellectual property developed by the co-founders in the course of business shall always be owned by the company. This is essential as the valuation of the company is also determined by the intellectual property owned by such company. However, the efficiency of this provision shall be determined on a case-to-case basis. For suppose, in technology-based sectors, it is often observed under the founders’ Agreement that the intellectual property is shared between founder and the company.

  • Restriction on transfer of shares

This provision can also be considered as one of the most important aspect to be covered under the Founders’ Agreement which provides conditions related to the rights and restrictions of the founders to transfer the shares of the company. In general practice, it has been observed that many founders’ agreement provides a lock-in period during which the founder(s) is/are restricted from transferring any of its/their shares in the company. This provision may also include to clarify the following understandings:

  • What shall be the mechanism to transfer share by a founder before the expiry of the lock-in period?
  • Whether the remaining founders shall have any ‘right to first offer’ for the concerned shares?
  • What shall be the method of valuation of the shares?
  • Whether there shall be an anti-dilution rights pertaining attached to such share?
  • Whether the remaining co-founders be vested with any tag-along and/or drag-along right?

Restriction of transfer of shares is applicable in laws irrespective of whether a company is public or private. This was upheld in the case of Riverdale Infrastructures Private Limited vs. Kirloskar Ebara Pumps Limited and Ors. [MANU/NC/6830/2020], wherein the NCLT Mumbai held that there is nothing unusual, unequal or extraordinary in the contractual relationship between them. While the principle in general is that the shares of a public company are freely transferable, there is nothing in law that stops two or more shareholders from entering into a covenant containing clauses for pre-emption, such as right of first refusal.

  • Non-Compete & Non-Solicitation

The purpose of this provision is to ensure that the founders shall maintain strict confidentiality of the business activities and shall neither solicit any personnel of the company nor engage in any business that conflicts with the business of the company. Usually, this restriction is applicable during the period of such founder’s association with the company and for a period of a certain number of years after his/her disengagement with the company.

The issue related to validity of non-compete obligation post termination of agreement has been under judicial scrutiny. Section 27 of the Indian Contract Act, 1872, provides that every agreement by which anyone is restrained from exercising a lawful profession, trade or business of any kind, is to that extent void. The courts in India have taken varied views in enforcing such a clause. It has been observed that the Indian Judiciary, while dealing with disputes relating to non-compete clause under an employment agreement, have segregated their opinion into two parts – (a) pre-termination period and (b) post termination period of the employment. The courts have been observed that such clause does not have an effect after the cessation of employment and have held that such a clause would fall within the mischief of section 27 of the Contract Act.

In the case of LifeCell International Private Limited vs. Vinay Katrela [MANU/TN/4323/2020], the High Court of Madras, by relying on the Supreme Court’s judgement in Niranjan Shankar Golikari Vs. Century Spinning and Manufacturing Company Limited [CDJ 1967 (SC) 078], stated as follows:

“There cannot be absolute restraint posed termination of the employment or in this case the trade agreement. When an employee or agent is given special training and imparted with special knowledge in respect of a particular trade, it is an intellectual property of the Principal and there could be reasonable restrictions. On the other hand, if an employee or agent acquired knowledge by his experience, which is individual to his intelligence portion, there cannot be any restriction and enforcement of the condition as per the agreement after termination is absolutely void. Therefore, depending on the circumstances and reasons, the negative comments can be ignored.”

Hence, in order to provide a valid non-compete clause, it has to be checked whether the restrictions upon the founders are reasonable or not.

  • Termination

Like any other commercial agreement, the Founders’ Agreement shall also have this provision where the right to terminate this Agreement by the co-founders shall be laid down. This provision shall entitle the parties to terminate the agreement upon occurrence of a particular event – (a) for cause by the other party; or (b) without any cause by the other party party; or (c) by mutual consent of all the parties. Now, whether a founder should possess all the rights to terminate the agreement (as mentioned under (a), (b) and (c)) shall be determined pursuant to the understanding between the parties and will vary on a case-to-case basis.

  • Governing Law, Jurisdiction & Dispute Resolution

As any other agreement, it is of paramount importance to state the applicable law and the courts which would have jurisdiction to any dispute arising out of the Founders’ Agreement. Unless there exist any foreign elements, the governing law shall be the laws of India. The jurisdiction provided shall either be on an exclusive or non-exclusive basis as maybe determined by the Parties.

Further, the Agreement shall provide a clear mechanism for resolution of disputes between the company and the co-founders with respect to any matter stated in the Agreement. In the interest of time, a corporate entity usually prefers to settle any of its dispute through alternate dispute resolution mechanism i.e., mediation, conciliation and arbitration. In such case, the provision shall provide details pertaining to the applicable arbitration law, number and appointment of arbitrators, seat and language of arbitration.   

Conclusion

It is pertinent to note that, besides avoiding conflicts between founders, a founders’ agreement also serves as an important instrument for the investors to gauge the management of the company before they invest in it. In the absence of this agreement, it is likely that an investor may not be very keen to invest in a startup which does not have a formal system of management agreed to by its founders. Thus, a founders’ agreement also implicates that the company has a robust governance system capable of dealing with any issues that it may face at a later stage. Therefore, it is imperative for the founders to have a formal, written founders’ agreement before they approach any investor with a proposal for participating in the funding of the company.

Author: Dippyaman Bhattacharya, Associate.

Disclaimer: The content of this article is intended to provide a general guide to the subject matter and that the same shall not be treated as legal advice. For any queries, the author can be reached at dippyaman@samistilegal.in

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