INTRODUCTIONOften, smart people of apparently like minds and common ambitions get together under the auspices of having a good idea and a notion that the idea might be the basis for an exciting and profitable business. This is indeed how many collaborations and ideas start. Early on, however, it is wise for founders to agree to a relatively short legal agreement that defines important terms to which the founders agree. As an important side note, if the founders can’t agree at the earliest stages as to the details of the corporation, then the likelihood they can stay together as an executive management team is dramatically reduced. Thus, in essence, the founders’ agreement is the first test of the future executive management team.
EQUITY DISTRIBUTIONThe first point of discussion among the founders is the equity share of the company at its founding (e.g., incorporation) that each will own. Often, among ostensible equals, the shares are split equally. Usually, one or more founders will have worked on technology and filed provisional patent applications under their names. Or, one of the founders may be perceived as the business lead (and likely starting CEO), and thus, among the parties, there is a collective agreeable viewpoint that all founders are equals for purposes of apportioning equity ownership.
Of course, a company can be formed from only one founder, in whom ownership is 100 percent. It is then up to the sole founder to secure the key members of the team, who may be called founders in many cases, based upon giving up some of his/her ownership in return for the services and loyalties of others. If that sole founder is also the key technology person who has filed one or more patent applications or provisional patent applications, then his/her position as majority equity owner is very strong. Nevertheless, the challenge for the founder is to share appropriate amounts of equity in order to build the starting team. With a single founder, there is no founders’ agreement required.
In some cases, one or more of the founders contributes intellectual property and/or cash for initial tasks of formation and securitization of the IP. It is entirely possible that each founder will be contributing different types of value to the company on day one. Evaluating what each particular contribution is worth in terms of initial equity distributions is then the subject of negotiation among the ostensibly equal founders. There is no simple formula or approach that can be applied. The distribution of equity will be simply be what the founders can agree to based on each person’s perception of his/her worth.
A common issue associated with the anticipated issuance of founders’ shares (e.g., common stock) is how those shares will be owned or vested over time. An all-too-common mistake of founders is to not associate founders’ shares (that are priced at a very small value, for instance, $0.00001 per share) with performance and/or devoted time with the company. Many war stories abound in which a founder takes a significant starting share of common stock without vesting requirements being attached only to quit after a period of time working for the company. That founder leaves the remaining founders with the burden of building the company and eventually having to dilute their shareholdings (to secure funding) even more than they would otherwise have to do if the departing founder had stayed with the company. This is obviously not fair, but more importantly; it severely debilitates the remaining founders. This issue is mitigated by vesting.
VESTING OF FOUNDER SHARESVesting requires that shares be earned over time (most common) or based on performance through the achievement of milestones (less common). Investors need to have a level of security with respect to the services of founders, and the common requirement is for shares to be earned over a four-year period, although longer periods of vesting are possible, depending upon negotiations with investors (see Chapter 9.6 of my book). On the other hand, if the founders have devoted a significant amount of time (before incorporation) to developing IP, then an argument can be made for a certain portion of the vesting period to be considered earned. This is problematic for investors, which is why incorporation early is advised, along with appropriate vesting requirements. Founders can also agree to a minimum period of time to be worked before some of the shares are vested. Or founders can require certain milestones before a portion of shares are vested. For instance, the filing and assignment of IP may be required before a portion of shares is vested.
Investment by a professional investor (angel or venture capitalist) may involve discussion of legal terms such as acceleration and triggers (see Chapter 9.6 of my book). These concepts can also be discussed among the founders during the formation stage of the company; however, it is generally premature to consider these terms. Keep it simple during the early stages, but you can also discuss with your corporate attorney the appropriateness of any particular term.
BOARD POSITIONSBoard positions should also be discussed in the founder’s agreement. While most founders expect to be part of the board of directors, not every founder may be suitable simply because of his/her position and title. What qualifies a founder as a board member depends on the contributions expected and the relative holding of shares. Founders to be designated (or chosen) by the board, such as the CEO, CFO, and CTO, presuming their credentials are suitable, are certainly qualified to be on the board. At times, lesser qualified individuals (but still founders) may wish to be on the board, but their suitability may be questioned by future investors. This issue must be discussed among the founders so that the founder perceived to be not qualified to be on the board is made aware of that future potentiality. Sometimes, this decision can be postponed until such time that a professional investor raises the issue and forces a change. The board should have an odd number of members so that ties are not possible. A board comprised of founding members among whom one is not believed to be qualified may need to discuss the issue and agree that an external board member will be elected at an appropriate later time to replace that board member.
POSITION, TITLE, AND RESPONSIBILITIESAnother area for discussion among founders is the position, title, and responsibilities of each founder. Responsibilities are commonly assumed according to the initial titles provided to each founder; for instance, CEO, CTO, etc. If a founder is not sufficiently credentialed or prepared to assume the higher or highest title for a position, a lesser title may be assigned. Thus, if a founder is clearly qualified to be a controller, but not the CFO, it is better to begin with the title controller rather than the higher title of CFO. Investors will understand and respect that decision among the founders.
SUMMARYEquity shares, vesting, and titles/positions are the important terms of a founders’ agreement. There are many other decision points to be established as part of the incorporation process, and, in theory, many of these can be part of the founders’ agreement.
However, at this early stage, it is recommended that discussion points be few and focused on the really critical issues among the founders. As opinions of founders can change in time, it is advised that the incorporation process be well underway so that there is a seamless transition into discussing other important issues in the company.
Does a founding team need a Founders’ Agreement? Perhaps not as the details talked about herein will eventually be addressed in the critical initial documents of the corporation. However, doing them early removes or diminishes problems that can occur later when founders are forced to make these decisions.
For a real life story of what can go wrong in the absence of a founders agreement, see the Los Angeles Times article at http://lat.ms/1yNAiOl.