When starting a business, it is essential to have clear and well-defined agreements that govern the relationship between the founders and the shareholders. These agreements can help prevent disputes, protect interests, and ensure smooth operations. Two main types of legal agreements are commonly used founders’ and shareholders’ agreements.
In this article, your lawyer cum entrepreneur buddy is going to delve deeper into these two types of contracts.
What is a Founders’ Agreement?
A founder's agreement is a legally binding document outlining the collaboration between the founders, such as the rules for the game they are playing. It also attempts to safeguard their interests in the business venture. It covers various aspects of the founders' responsibilities, commitments, and ownership rights, such as equity allocation, roles and duties, intellectual property ownership, and dispute resolution. A founders’ agreement helps to establish trust, transparency, and accountability among the founding team.
Anatomy of founders’ agreement
A standard founders' agreement includes several key clauses to ensure clarity and accountability within the team.
1. Roles and responsibilities
This clause is a staple of almost all founders’ agreements. It defines each founder's specific roles and responsibilities within the company. This clause helps clarify each founder's specific duties and ensures all team members know their responsibilities.
2. Equity ownership
Another key clause in a founders' agreement is equity ownership and distribution. This clause clarifies the confusion around how the business ownership will be distributed among the founders, including the allocation of shares or ownership percentages.
3. Intellectual property ownership and protection
This clause pertains to intellectual property ownership and protection, including patents, trademarks, copyrights, and trade secrets. It can be instrumental when one founder contributes intellectual property to the business, and others are not.
4. Vesting of founders' shares
In our experience, any investor worth their salt would only invest in a business once vesting has been put in place. Founders' shares may be subject to vesting, meaning they earn ownership gradually over a specific period to incentivize long-term commitment and mitigate risks associated with founder departures. Typically, vesting is for four years, but I have seen cases where it has been negotiated down to three years, especially in situations where founders started working on the venture before its incorporation.
5. Non-compete and non-disclosure clauses
Non-compete and non-disclosure clauses are also critical elements of a founders' agreement. These clauses prevent founders from competing with the business during their tenure and ensure the confidentiality of sensitive company information.
6. Dispute resolution mechanisms
Finally, the agreement establishes mechanisms for resolving conflicts or disputes among the founders. These mechanisms can include mediation, arbitration, or negotiation and help ensure disagreements don't escalate and disrupt company operations.
Importance of a Founders’ Agreement for early-stage startups
Founder agreements are essential for early-stage startups. They lay a robust working relationship, goals are aligned, and a framework for decision-making is provided. Misunderstandings are prevented, expectations are clarified, and the founders' interests are protected, a crucial requirement for startups in their nascent stage.
In my personal experience, I have seen several disputes over equity distribution, differing interpretations of roles, or disagreements regarding intellectual property rights, which can lead to significant challenges and even legal battles.
Founders with well-drafted agreements are better equipped to navigate such situations, ensuring a smoother journey for their business. Several high-profile cases have emphasized the importance of founder agreements, demonstrating the value of comprehensive and legally sound documentation in protecting founders’ rights and maintaining business stability.
What is a Shareholders Agreement
A Shareholders' Agreement is a legal document that outlines the rights, responsibilities, and obligations of the shareholders of a company. It is usually longer and more complex than a Founders Agreement and is typically put in place when a start-up issues shares to external investors. A shareholders' agreement provides a framework for the relationship between the company’s shareholders and investor rights. It also provides for decision-making and conflict resolution.
What should you include in a Shareholders' Agreement?
When external investors come on board, addressing issues beyond the arrangements between the founders becomes essential. A shareholders' agreement will typically contain the following provisions besides details of the business and the shareholders.
1. Share ownership
This clause clearly states the type and number of shares held by each shareholder, along with the rights and privileges of each class of shares.
2. Management and Control/Board Appointments
This clause should cover essential topics such as the role of the board of directors, the appointment or removal of board members, and the process for making major business decisions. Shareholders may have the right to appoint a board member.
3. Dividend Policy/Rights
This clause deals with the timing and frequency of dividend payments. Investors may have the right to receive a specific preferred dividend.
4. Shareholder Obligations
Shareholders may have obligations such as maintaining confidentiality, providing financial information, or attending shareholder meetings.
5. Shareholders' Rights
Shareholders are entitled to specific rights and protections based on the class of shares they hold, usually referred to as preferred shares. These rights are designed to safeguard their investments.
6. Share Transfer Restrictions
Share transfer restrictions limit a shareholder’s ability to transfer their shares. The purpose of share transfer restrictions is for the company to control who owns its shares, protect investors from founder departures, and allow existing investors priority on purchasing shares. Sometimes, some of these restrictions are exclusively in favor of preferred shareholders. Alternatively, they may be exempted from these restrictions.
7. Rights of First Refusal, Drag-Along, and Tag-Along Rights
A Right of first refusal gives the holder a priority right to buy or refuse to buy any existing shares from another shareholder before that shareholder can sell to a third party. It is closely related to a Right of First Offer, meaning the shares must first be offered to the holder of the right of first offer before it can be provided to anyone else. Significant investors are often exempted from the obligation to offer their shares to other shareholders first.
Drag-along rights allow majority shareholders to force minority shareholders to sell their shares to the same buyer on the same terms as agreed to by the majority shareholders. Drag-along can be an essential right to ensure that a minority shareholder does not block the sale of the company.
Tag-along rights give minority shareholders the right to “tag along” when shareholders want to sell their shares. So, when shareholders propose to sell their shares to a third party, the investor with a tag-along right may also sell a portion of their shares to the same buyer at the same price. Major investors might want to avoid being subjected to other investors’ tag-along rights.
8. Anti-dilution Rights
Anti-dilution rights are an example of an investor protection clause. It protects investors from excessive dilution of their shareholding in follow-up fundraising rounds when you raise funds at a lower valuation and issue new shares at a lower price than the investor paid. It allows investors to maintain their ownership percentage when new shares are issued. Anti-dilution rights can grant the investor additional shares for free or will enable the allocation of proceeds to be adjusted upon an exit.
9. Liquidation Preference
Liquidation preference is the most significant financial right investors have. It sets out what happens during a liquidity event, i.e., when the investment is converted to cash. Regarding liquidation, the preferred shareholder will get “preferred” treatment over ordinary shares. Preferred shareholders will receive a certain amount of money before any other shareholder when the company has cash to distribute to shareholders. The preference applies to the company's liquidation, winding up, or dissolution. It also includes liquidity events such as the company going public or being acquired.
10. Rights relating to reserved matters
Reserved matters refer to certain important decisions reserved for approval by investors (Either at the shareholder or board level or both. It means that investors can veto decisions in these matters.
Reserved matters could include decisions related to significant business transactions, senior appointments, litigation, changes to the company’s capital structure, issuing new shares, etc.
This right can be expressed as some decisions requiring that a certain percentage of preferred shareholders must vote to approve any action relating to these matters. At the board level, one or more board members appointed by the investors must authorize the action.
11. Voting rights
Other than reserved matters, the agreement should specify the Shareholders' voting rights, including any special voting rights for certain classes of shares.
12. Founder restrictions
Investors could insist on the right to restrict founders from doing certain things. For example, they could insist on a lock-up restriction prohibiting the founder from selling their shares for a specific period.
13. Dispute resolution
The agreement should set out provisions for resolving disputes among shareholders, such as mediation, arbitration, or litigation, and the specific jurisdiction for dispute resolution.
14. Exit strategies
The agreement must stipulate options for shareholders who want out, such as selling their shares or initiating a buy-out.
Founders’ Agreement vs. Shareholders’ Agreement
1. The Main Objective
A Founders Agreement focuses on the roles and responsibilities of the founders. It also sets out the equity allocation and who can decide what. It typically also addresses vesting and leaver arrangements for the founders. A Shareholders Agreement focuses on the relationship between the shareholders, including investors. It includes voting rights, restrictions on share transfers, and other governance matters.
2. Language and Content
Typically, a Founders Agreement may cover topics such as the company’s vision and mission, the roles and responsibilities of the founders, the division of equity and ownership, vesting schedules for shares, and intellectual property ownership. A shareholders' agreement may cover voting rights, share transfer restrictions, shareholder obligations, dividend policies, dispute resolution procedures, etc.
3. Timing
A Founders Agreement is typically agreed upon at the beginning of the start-up’s formation. A Shareholders Agreement is usually created when the company brings on external investors.
The critical elements of both Founders Agreements and Shareholders Agreements may vary depending on the specific circumstances and needs of the company. There might be overlaps between the two documents, but the difference can be found in the main elements of each.
Sources:
- Quality of Software Development – The Main Factors | Perfsol. https//perfsol.tech/blog/quality-of-software-development-the-main-factors-secrets-of-success
- Guide to investor rights - Clara. https//clara.co/guide-to-investor-rights/
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