Key Terms to Include in a Founders’ Agreement

As a company scales, one of the most important things co-founders can do is formalize their relationship. Yet Forbes lists the absence of a founders’ agreement among the top 10 legal mistakes made by startups. And poorly-constructed agreements lead to founder conflict which, according to Y-Combinator co-founder Paul Graham, is one of the most fatal mistakes that kill startups. Where do most agreements go wrong? What key terms should your founders’ agreement (FA) include?

We talked to a range of leading entrepreneurs about their personal experience with founders’ agreements. Some successfully operated without formal, written founders’ agreements. Others eagerly established formal agreements at the outset that ended disastrously while others carefully crafted agreements over time that have helped keep their company on course. We can’t give you a precise rule for creating a founders’ agreement and some co-founder conflict is inevitable. But we can provide a framework that will help you avoid common mistakes and equip you to handle conflict.

Roles & Responsibilities

When co-founders possess distinct individual skills, roles can fall into place organically and you may be tempted to forgo writing a founders’ agreement. For instance, when three co-founders launched BlackBuck in 2015, they divided roles according to skillset. Each agreed to accept a functional lead that aligned with their skills: fundraising, operations, and sales. But many co-founders have a significant overlap in skills and expectations. Addressing key terms—roles and responsibilities—in your founders’ agreement becomes critical.

Defining Who Does What

BlackBuck’s co-founders decided not to write a formal agreement at the outset. However, they took the time to clearly establish expectations about responsibilities and role divisions. Alignment on those decisions enabled their startup to scale exponentially. Between July and December 2015, they expanded from three locations with three clients to 54 cities with 50 clients and the team grew from 35 employees to 250. In less than two years, they developed a technological platform and built a network that completely revolutionized India’s trucking industry. By the end of 2018, BlackBuck grew to over 2,000 locations, serving 10,000+ clients.

The decision to forgo a written founders’ agreement worked for BlackBuck because they shared complementary expectations and verbalized their agreement about roles and responsibilities.

Title Expectations

BlackBuck’s founders also unanimously agreed upon titles and who would serve as CEO. That scenario is relatively rare. Often, when two or more co-founders exist, each expects to become CEO. Planning to discuss your expectations for titles and general responsibilities with your co-founder early can mitigate future conflict.

Inevitably, during early stages—when uncertainty abounds—and scaling—where needs change rapidly—titles and roles may shift. You can stipulate that roles will be reevaluated periodically, such as every six months, and, if necessary, redefine titles and roles to reflect changing needs.

Delineating titles and roles shouldn’t limit a co-founder’s role. Instead, it helps provide structure by distributing responsibilities.

Rights & Rewards

Founders’ rights tend to change once investors get involved, so clear delineation at the outset can help to avoid future conflict and create a culture of openness.

Decision Rights

This section of your founders’ agreement covers two primary areas. First, it defines who holds final authority within different aspects of the business. Second, it stipulates what circumstances matter.

Most founders make decisions based on their experience, roles, and expectations. Sometimes, perspectives don’t align. Lacking a decision-making path can lead to conflict. For example, a technical co-founder might set a one-year goal for developing a product, while a business-oriented co-founder might want to guarantee investors that the product will be ready in 6 months. Who has the right to override which decision, given that decisions affect the same pool of resources?

Some critical decisions—like key hires, equity grants, removal of a founder, long term commitments, and raising new equity—require the Board’s approval. Typically, they also need consensus from all founders. What happens if you disagree? Your founders’ agreement should address you you will resolve disagreements and deadlock.

Even if you plan to promote a collaborative culture, not all decisions should be made collectively. Your founders’ agreement  should  stipulate who has the right to make any given decision. It should  propose a course of action if partners disagree.

Rewards

How much compensation should each co-founder receive? Most founders ask themselves, “what percentage of ownership will I get in return for what I am putting into this venture?” Wasserman discovered that 73% of founding teams split equity within a month of founding. But when crafting a founders’ agreement, equity is the last item that you should discuss.

Most founders opt to divide equity equally or calculate a percentage of equity split based on the contributions each co-founder makes. Many approaches and methods for calculating equity exist. But calculating percentages is highly subjective. Calculations are often based on the founders’ past contributions—which many overvalue—and expected future contributions—which are impossible to accurately predict.

While your FA can cover the allocation of equity, you also have the option of making the equity split a separate legally binding document. Read more about deciding how to allocate equity in How To Think About Equity Splits. When discussing equity and decision rights, resist the common temptation to conflate the two.

For instance, a technical co-founder who contributed the founding idea and IP may have a higher equity stake with lower decision rights. The percentage of equity ownership and decision rights do not have to match. Consider structuring your FA to address equity and decision-making separately.

Board Positions

At the start of a company, all founders have representation on the board. Typically, following the seed round, founders can specify who will represent the company on the board, and stipulate observer rights for other founders. An observer can attend Board meetings and participate in Board discussions but does not have the ability to vote on issues. Establishing observer rights minimizes the risk of co-founders feeling excluded.

Commitments

Time & Interest

It is important to take into account whether each founder will work full-time or not. For instance, at an early stage company, one co-founder may work full-time, while the other works half-time on the venture while continuing to work half-time elsewhere. Retaining a role in another company minimizes the risk for that co-founder. Similarly, since many founders want to have the ability to take advantage of opportunities—as investors, consultants, etc.—outside of the startup, you also need to agree on basic time issues. How many hours constitute full-time? If one person follows a 50-hour work while the other consistently works 80 hours per week, resentments will begin to form.

Intellectual Property (IP)

When you and your co-founders iterate on an idea and develop a business plan or begin to build a product or a platform, you are creating intellectual property (IP).

Securing IP is a good business practice and prevents a technical co-founder from walking away with a crucial patent if he or she leaves the company. Equally important, it can protect you. If you own the IP for an algorithm and allocate it to the company, it’s no longer yours. If the company fails, you have lost any rights over the IP you created.

Your founders’ agreement can introduce appropriate IP assignment provisions. Incidentally, your startup should secure IP rights not only from your co-founders but from your employees, consultants, and contractors.

Network

Some founders have a strong network they are willing to share that would increase the chances of a company succeeding. Others feel reluctant to share their network initially, while they’re unsure of the future success of the company. For instance, when launching Endeavor, a nonprofit that promotes the power of entrepreneurship, co-founders decided to split equity equally. However, when the company developed in a way that differed from the original vision, the co-founder who disagreed with the venture’s new direction, refused to share his network. Without a provision about founders’ networks in an FA, a founder can continue to retain original equity in such a case.

Capital & Confidentiality

Your founders’ agreement should list if either founder contributed personal funds to the venture and describe the terms for capital usage. To demonstrate commitment and protect valuable business information, your FA should also include a standard confidentiality clause.

Contingencies

Even with a thoughtfully crafted founders’ agreement, unpredictable issues will arise. Your FA can provide provisions that help establish a process for dealing with unexpected scenarios, such as if a partner leaves. Founders often don’t feel the need for contingency provisions, but at a minimum, including a vesting period for all co-founders can protect your startup and your relationship.

Vesting

Instead of receiving equity rights instantaneously, vesting defines the criteria co-founders must meet to earn their equity. Commonly, vesting stipulates that founders must either work for a set period of time or meet certain milestones before their equity becomes available. Vesting provisions help ensure that co-founders will remain actively involved in and committed to the startup. The most common time-based vesting term occurs quarterly over four years, with a one year cliff. That means that the vesting schedule will not be enforced for the first year. Most founders opt to include a time-based vesting schedule in their FAs, despite the fact that time-based vesting only measures the quantity of time, not the quality of work.

Recap

A founders’ agreement serves several important functions. On the most basic level, it establishes the roles, responsibilities, and rights of founders. It gives co-founders the opportunity to negotiate a shared vision. Perhaps most importantly, it provides a way to resolve future contentious issues. Many helpful online resources exist to help you get started on drafting a founders’ agreement with standard terms and provisions. But don’t rush the process. Plan to have ongoing conversations and document your expectations in writing, especially if areas exist where you and your co-founder disagree.

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