Pitfalls of not having a co-founders’ agreement


By Roma Priya

Conceived an once-in-a-lifetime business idea and exhilarated to crack the opportunity jointly with more people? There might be a lot of excitement in the air where each founder might already be feeling the rush to get the new enterprise off the ground, but before any further move, you need to take a deep breath and recall whether you have completed all the procedures and paperwork before commencing the business. Procedures here indicate the legal items, which are essential to protect the business at present and in future.

If the plan is to set up the business with co-founders, it is crucial to get the co-founders’ agreement in place thus saving on a lot of hassle, money and confusion. After all, there is a possibility of situations and expectations changing, resulting in mental and financial woes for the co-founders who are planning only for the present and ignoring the potential hitches. A co-founders’ agreement outlines the rights and responsibilities of the co-founder that can help in avoiding any conflict that might arise among co-founders in future.

Ideally, the co-founders must think through any potential problems that they or the business might face and brainstorm solutions for the same. However, it is still necessary to have conversations on topics like selling of the business, co-founder leaving the country for a lucrative job opportunity or one of the founders not performing well and the recourse available in such case. Here are some of the essential clauses that must go into the co-founders’ agreement:

1. Names, roles and responsibilities of co-founders in the company

This might seem basic, but it is extremely essential to have all these details in place so that everyone associated with the business is on the same page in terms of ‘what responsibilities are each one of them sighing for?’ How much time, energy, and perhaps money each founder is putting into this company?

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2. Decision-making

Apart from defining the responsibilities, it is crucial to pen down the decision-making power of each co-founder. Who can sign the cheques and authorise bank transfers? Shareholding rights of the co-founder? How to hire candidates? Who will take charge of termination in case of dishonesty, fraudulent activities & failure to reach the agreed milestones etc?

3. Equity breakdown and vesting schedule

While equity is usually split equally between all the co-founders, it sometimes does not justify what each of them is bringing to the table. This might result in arguments later stage if a co-founder fails to achieve the target set at the onset of the business. Thus, an agreement should include the equity that is to be divided among all the co-founders based on their domain expertise, capital, time devoted, resources and responsibilities.

As much an equity breakdown is important in the agreement, so is defining the vesting schedule. If co-founders get their share all at once, chances are they might just lean back and leave the responsibility on others. By creating a vesting schedule, which is often four years with equal quarterly or half yearly or yearly vesting co-founders will stay motivated to earn their keep. For instance, if a founder leaves before one year, they get no shares. If any co-founder leaves before the full vesting, the unvested shares may be nullified and absorbed into the company. It is to be understood that the above scheme of vesting is one such example generally practised while it is open to the co-founders to negotiate on the same.

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4. Intellectual Property ownership

An Intellectual Property is something which is being created by the co-founders of a business entity when they start building the idea. So, it is important to make sure that whatever IP is being developed for the company, belongs to the entity itself and not any particular person behind the development of the IP, i.e. co-founders, employees, consultants and contractors. Although, it is not likely to create a problem, but in case an individual decides to break away and form a successful competing business with the same innovative idea, it might just be a problem to the existing company. Thus, to protect your intellectual property, mention this clause on the agreement.

5. Remuneration and Compensation

It is a basic yet significant part of the agreement. Co-founders usually overlook discussing these rudiments while setting up the entity but a co-founders’ agreement obligates them to acknowledge it, in order to avoid any uneven expectations everyone might be bringing to the table. However, it is up to the co-founders to create a definite compensation plan that takes into consideration the future growth of the company.

6. Exit Clauses

Lastly, a co-founders’ agreement should also mention the circumstances of exiting from the roles and responsibilities in case of underperforming co-founders and voluntary departures. While deciding on these clauses can be stressful, it can help in figuring out what happens with the unvested shares. Penning the exit clause on the co-founders’ agreement would indicate that everyone had agreed on the decision previously.

While a co-founders’ agreement should be made at the early stage of setting up the business, it might need alterations as the business grows and takes external investment. After all, there can also be a downside to having agreements that are not suitably tailored to the business or lack precision. Being overly rigid can choke a business, whereas an unfocussed agreement can lead to clashes. Thus, to avoid any unforeseen situations, owners, especially the startup founders can make a wise move by consulting external legal services. This would not only help them in creating a sound co-founders’ agreement, but also leverage their business relationship and the future growth of their company.

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(Roma Priya is Founder- Burgeon Law)





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