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The Founder’s Agreement

Protect Your Assets

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If they are with you at take-off; they’ll be with you at the landing…

“Honeymoon” is the term used for the young years of a business, for good reason.  Optimism abounds.  The Esprit de Corps of the development group has everyone happily agreeing.  Tough conversations are delayed.  Differences are ignored.  No one wants to ruin “the mood.”  Founders can fall prey to early optimism, and procrastinate making some of the tough decisions during this “Honeymoon.”

Addressing the necessary aspects included in a Founder’s Agreement will not take long.  Everyone will be relieved and feel even better once there is an agreement on these uncomfortable subjects.  The business will be more legitimate to investors.  Company executives and employees will better grow the business using the Founder’s Agreement infrastructure in place.

WHO ARE THE PARTIES OBLIGATED BY A FOUNDER’S AGREEMENT?

The Founder’s Agreement is a contract:

  • Between the business Founders (Owners)
  • Between the Founders (Owners) and the Business Entity

WHAT IS THE PURPOSE OF A FOUNDER’S AGREEMENT?

The purpose of the Founder’s Agreement is to make specific key-concrete aspects of the business organization.  

  1. The first goal of a Founder’s Agreement is to create a contract between the founders of the business. 
  2. The second goal is to create an agreement between the business entity and the founders.  Remember; a primary purpose of creating a business entity is to protect the founders and their assets from business liabilities and culpability.  It is all too easy and common for founders to treat the business as their alter ego.  However, such mistakes of over control by a founder come at the expense of the primary benefits of the business entity … protection. 

How can they be considered a
Founder?!

Who may be considered a “Founder” is a trickier situation than one may imagine. United States law indicates all inventors have an equal share in the intellectual property rights over an invention irrespective of their degree of contribution in the invention creation. Founders who primarily create and nurture a business idea frequently overlook possible minority inventors.

These other “Founders” can include:

  • Independent contractors

  • Employees

  • Former employees

  • Spouses/friends/significant others

  • Other businesses with similar assets/inventions/processes

WHAT ARE THE NECESSARY TERMS TO INCLUDE IN A FOUNDER’S AGREEMENT?

The primary subjects addressed in a Founder’s Agreement are:

  • Business goals/purpose

  • Ownership Structure

  • Percentage of ownership

  • What percentage of business ownership will be kept in reserve for future capital investors?

  • The degree of power/control over business operations that comes with business ownership

  • What actions each owner is expected to contribute

  • Whether the founders will be the managers of the business, and if so, whom and to what extent

  • Whether any of the Founders will fulfill some other specific role/function

  • Whether any of the Founders will be merely a Passive Investor

  • The business areas in which each Founder is not expected to meddle

  • The amount of work/effort expected of each Founder

  • Ownership of business tangible assets

  • Ownership of business intellectual assets

  • Use of business confidential information

Include an obligation by the Founder to take all actions, refrain from certain actions, and execute all documents necessary to transfer ownership of the business concept, assets, and information ownership to the business entity.

  • Founder’s Rights, such as whether each Founder will have identical rights or whether a different distribution is contemplated for aspects such as voting power, distribution rights, and vesting.

  • Money: Who will contribute? Who can use the business money? How? When?

  • Owner salary

  • When each Founder can liquidate (sell) their Ownership interest

  • Vesting schedule with percentages available to sell and time deadlines

  • To whom each Founder can sell their ownership interest

  • The process that will be employed for the sale of ownership interest

  • Ownership Transfer: What limitations will be placed on the ability of a Founder to transfer their business ownership interest?

Future agreements, such as employee ownership plans, mergers, acquisitions, funding rounds for new investors and liquidation that will require each Founder to decrease their relative share of business ownership. 

What happens when a business owner wants to leave, or is unable to continue in the role to which they have been assigned?   People get old, become disabled, move, change their minds, die.   This is life and will happen to us all.  Business Founders need to agree upon a process for managing these changes when they occur. 

Under what circumstances can a Founder be removed?

How and to what degree a Founder can lose their ownership interest for certain activities or omissions, such as failing to participate in business operations, or other violations of the Founder’s Agreement.

  • What qualifies as removal for cause?

  • Who votes for a Founder’s removal?

  • Is a simple majority or a super majority vote needed to remove a Founder?

  • Who all has the decision making power within the business?

  • What process will be used to resolve internal disputes?

  • What laws, rules, regulations, and procedures the business will use

  • Business location(s)

  • Under what circumstances can the business be ended?

  • What events or failures justify the ending of the business?

  • Who votes for the ceasing of business operations?

  • Is a simple majority or super majority needed to cease business operations?

  • Amendments to the Founder’s Agreement: Under what circumstances are amendments allowed?

  • Entirety: A statement that this is the entire Founder’s Agreement and that there are no unattached addendums, amendments, prior agreements, or separate contracts containing different terms on the same subjects.

WHAT ARE THE OPTIONAL TERMS FOR A FOUNDER’S AGREEMENT?

  • Separation agreements for situations where the Founders agree, provide assets to start the business, yet the business fails to form in a given time period or fails to achieve some other necessary pre-requisite objective.

  • Deadlock provisions; on how to proceed if the Founders disagree and cannot come to terms with some pre-defined necessary business aspect. Deadlock provisions are solved by a number of methods. These include:

  • _ _ _ Escalation: delegating the tie break to a certain executive or group of executives

  • _ _ _ Manager Tie Break: naming a certain person as a tie breaker

  • _ _ _ Independent Tie Breaker: delegating the tie breaking vote to an independent person or group.

  • _ _ _ Buy-Sell: One Founder has the option to buy the other Founder out and decide themselves.

  • _ _ _ Russian Roulette: One Founder naming a price to agree with them or be obligated to sell their shares to them at that price.

  • _ _ _ Texas Shoot Out: Sealed envelopes with a price to settle the dispute with the later-revealed amount of money going to the other member with the decision authority deciding.

  • _ _ _ Dutch Auction: Each Founder submits a sealed envelope with the lowest price they are willing to sell their shares to the other member. The Founder with the highest price then buys the lower bidding founder’s shares at the lower price submitted along with the authority to make the decision.

  • _ _ _ Adjusted Fair Market Value: An Auditor or Expert is agreed upon and determines the fair market value of the shares. This triggers a buy-sell provision where one member must either buy the other Founder’s ownership shares at a pre-determined premium or sell their shares at an equivalent discount to that other Founder.

  • _ _ _ Timelines to achieve business objectives

  • _ _ _ What is to occur if the timeline for the business to achieve its objectives must be increased?

  • _ _ _ What will occur if additional capital contributions become necessary for the business to remain viable?

  • _ _ _ Right of First Offer; requiring the business entity to offer to the Founders first the right to buy a percentage of the business, such as common stock shares held in reserve, before offering the stock ownership to third parties. The right of first offer typically includes a time period a process of accepting or declining the Offer, and whether the Founder must be offered terms superior than those offered to third parties.

  • _ _ _ Right of First Refusal; contemplates the privilege of a Founder to buy part of all of their ownership interest of another Founder when a third party makes a bona fide offer to purchase that Founder’s ownership share. A Right of First Refusal provision typically does not contain a requirement that the third party who wants to buy that Founder’s ownership shares be identified.

  • _ _ _ Open Marriage Clause: To what extent can Founders involve themselves in other business ventures?

  • _ _ _ Competing business ventures

  • _ _ _ Complementary business ventures

  • _ _ _ As passive versus active members

  • The three procedural options to resolve breaches of the Founder’s Agreement:

  • . . . . 1. A Lawsuit: Do you use the formal legal in court process to resolve the issue?

  • . . . . 2. Arbitration: Do you hire an independent expert with the power to decide?

  • . . . . 3. Mediation: Do you hire an independent expert to broker a deal between the parties in disagreement?

  • Exclusivity, also known as an Interfering Parties, Obligations, and Activities Provision; where each Founder warrants they are not required by some other agreement that interferes with their Founder’s Agreement obligations, and that no third party can claims rights over the assets, activities, and ownership the Founder is transferring to the business entity

  • Non-Violation Clauses: This contract clause obligates the parties to warrant that they are not violating some other duty or contract by agreeing to the Founder’s Agreement terms.

  • Notary Public Seal: Some jurisdictions will require that a Notary witness the signing of the agreement. Those jurisdictions will require that the Notary’s Seal appear on the Founder’s Agreement to verify the signature for the contract to be legally enforceable. An example is a transaction dealing with real estate. The terms included in the Founder’s Agreement will weigh heavily on whether a Notary Seal verification will be needed.

  • Two Independent Witnesses: Some jurisdictions will require two independent witnesses to sign the agreement to verify that the Founder was indeed the person who signed the contract. The terms included in the Founder’s Agreement will weigh heavily on whether Two Witness verification will be needed. An example is when a founder grants a Power of Attorney.

  • Attorney’s Fees: Parties in disagreement are often self-righteous and ready to fight as long as they perceive they have an easy or honorable exit if the disagreement goes against them. The disagreeing party is happy to pay a lawyer to fight in their stead. Attorney’s fees clauses increase the potential cost to parties who are in the wrong; they reduce the harm to parties who are in the right. Attorney’s fees clauses have the added benefit of reducing the incentive to disagree by increasing the potential cost of the dispute. There are two ways to draft an Attorney’s Fees clause:

  • _ _ _ A . . . Prevailing Party: This is the most common and most balanced version of an Attorney’s Fees clause. Prevailing Party clauses award the right to reimbursement for reasonable attorney’s fees to the party who the Judge, Jury, or Arbitrator decides is right.

  • _ _ _ B. . . Drafting Party Only: Life is not fair, and contracts often mimic life. The drafting party of a contract is frequently the party with the bargaining power. The last thing such a party might want is to draft a clause into their own contract, unnecessarily, where they must pay another party’s attorney’s fees. Thus, Attorney’s Fees clauses are frequently (though not the majority of time) drafting to award attorney’s fees to only one party … the drafting party.

  • Liquidated Damages Clause: These clauses address two issues.

  • _ _ _ First, it can be difficult to calculate the degree of harm to a breach of certain types of contracts. Damages can be speculative, or hard to quantify in terms of money lost.

  • _ _ _ Second, some damages can be quite harmful in one sense even though the fair market money value of the loss would be quantified as low. Think of losing a beloved pet or a family heirloom.

Liquidated damages clauses solve these two types of issues by having the parties agree as to the amount of damages, or the minimum amount of damages in advance. 

  • Force Majuere: This contract clause sounds like Latin but it is actually French. A Force Majeure clause releases the parties from their obligations when an Act of God makes performing the contractual duty impossible. Think of a flood, and the like.

  • Severability: Lawyers typically seek to have every clause in the contracts they write legal and enforceable. However, when challenged, courts occasionally rule that certain contract clauses are illegal, or unenforceable. The Severability clause seeks to “sever” out illegal or unenforceable clauses without making the entire contract void.

  • Indemnity: This clause states that party number one to the contract will compensate any other party for if party number one violates the contract.

  • Termination for Convenience: Founders love, and hate these clauses. A Termination for Convenience clause allows one party to end the contract irrespective of whether any of the contract’s terms have been violated. Termination for Convenience clauses are a luxury and give power to those who have them; but these clauses add uncertainty to the relationship.

  • Termination: This clause allows the Founder’s Agreement to terminate naturally, without formalities, when a pre-defined event occurs. The terminating event could be a set time period. The event could be a set amount of money capitalization. The terminating event could be when the business goes public. Terminating events are left to the desires and imaginations of the drafting parties.

WHAT TERMS SHOULD NOT BE INCLUDED IN A FOUNDER’S AGREEMENT?

Non-Compete Clauses:  Terms agreeing not to compete during a Founder’s involvement with the business venture should be mentioned and referenced to if that is part of the agreement between the Founder and the business.  Terms agreeing not to compete with the Founder’s business even after the Founder leaves the business should be mentioned if that is the case.  However, non-compete clauses should not be integrated specifically into a Founder’s Agreement.   This is because a court interpreting the non-compete clauses could invalidate the entire agreement, including the Founder’s Agreement clauses if that court finds the non-compete clauses illegal, or unenforceable.  Also, non-compete agreements need to be specific and merely adding clauses is inadequate.  Third, one should want to keep agreements specific and not too long.  It is better to separate Founder’s Agreements from Non-Compete Agreements. 

NSA Non-Solicitation Agreements:  These agreements bar the parties from luring employees, and contractors away from the business.  These are very specific agreements that should be addressed separately.  Also, there is the risk of a court invalidating the entire agreement when it potentially invalidates a poorly written Non-Solicitation Agreement. 

 NDA Non-Disclosure Agreements:  Also called “Confidentiality Agreements,” these seek to protect the confidential, proprietary information used by the business that is not publicly available.  Care must be taken in drafting and enforcing a non-disclosure agreement.  They may and should be illuded to in business contracts, such as the Founder’s Agreement.  However, the non-disclosure agreement should be a separate document.  Non-disclosure agreements bear the same severability and invalidity risks as non-compete and non-solicitation agreements. 

 PIIAA Proprietary Information and Invention Assignment Agreements:  These are the most important contracts a business needs that most people have never heard of.  The PIIAA ensures that the business owns what it thinks it owns.  It is important for each Founder to assign the business concept, assets, intellectual property, and other means to the business as part of a separate, stand-alone agreement and not just a clause in the Founder’s Agreement.  Care needs to be taken in spelling out what is, and what is not assigned for the utility of these agreements to exist. 

 Operating Agreement clauses:  The Operating Agreement spells out the rules, procedures, and policies the business will follow, internally.  The Operating Agreement is about the relationship between the business entity and its employees.  It is different and should be separate from a Founder’s Agreement. 

 By-Laws:  By-Laws are similar to Operating Agreements.  The difference is that By-Laws are more specific than Operating Agreements. 

 SAFE Simple Agreements for Future Equity:  It is unusual for a Founder to be a party receiving the right to future stock via a SAFE Agreement.  This is because Founders start with 100% of the ownership of the business and do not need a promise for future ownership.  Such promises, however, are possible.  SAFE Agreements should not be integrated into Founder’s Agreements.  SAFE Agreements are specific, differ from Founder’s Agreements, and should be separate. 

 SAFT Simple Agreements for Future Tokens:  SAFT Agreements are cryptocurrency’s version of the SAFE Agreement.  It is unlikely that a Founder would need a promise from the business entity to provide the Founder with a crypto token digital asset in the future in exchange for some value from the Founder.  This is because the Founder is likely a 100% owner of any digital asset produced, at some time.  Still, a Founder being the beneficiary of a SAFT promise is possible.  SAFT Agreements should be separate from Founder’s Agreements as they involve different topics.  SAFT Agreements may be invalidated by a court as an unauthorized issuance of a security and one should avoid severability issues whenever possible. 

 Executive Compensation Agreements:  Founders and executive officers usually are different people.  The issues raised in a Founder’s Agreement differ substantially from Executive Compensation Agreements.  Also, each type of agreement can be rather long.  These types of agreements should be separate. 

 Equity Incentive Plans:  These plans deal with the compensation employees should receive and do not deal with Founders’ compensation.  Even if a Founder wounds up being compensated under an Equity Incentive Plan, the two agreements should be separate. 

WHY WOULD DIFFERENT FOUNDERS HAVE DIFFERENT/UNEVEN RIGHTS AND OBLIGATIONS IN A FOUNDER'S AGREEMENT?

Little in life is identical.  Differences are often strengths, and the forming of business relationships typically involves different persons, with different skills, experiences, and contributions coming together to form a successful venture. 

 The Founder’s Agreement functions to formalize differences between Founders to prevent misunderstandings and fix disagreements.  Uneven Founder’s Agreement rights and obligations arise from uneven contributions, such as:

  •  Ownership/invention of the key business concept
  • Ownership of the intellectual property, patents, trademarks, copyrights
  • Development/knowledge of the key technology
  • Relative degree of capital investment
  • Relative time investment between Founders
  • Degree of participation of the business development
  • Opportunity cost differences between Founders
  • Relative difference in expertise between Founders

IS A LAWYER USEFUL DURING THE PROCESS OF CREATING A FOUNDER’S AGREEMENT?

Yes, Founders and their business executives really should employ a lawyer to draft their Founder’s Agreements.  These contracts are specific, involve nuance, always involve issues that will be specific to the jurisdiction (location) where the business is headquartered, and operates, and there will be clauses that need to be specifically tailored between the laws applicable to the business and the business operations and situation itself.  This takes a lawyer with specific expertise in Founder’s Agreements.  

 Lawyers spend their careers dealing with difficult, unpopular issues.  It is wise for business managers to delegate unpopular tasks, such as a Founder’s Agreement.  Let the Lawyer be diplomatic and accomplish this task. 

 Founder’s Agreements are not that expensive to draft, despite their importance and the many areas in which they can be erroneously drafted.  A competent lawyer, armed with the wishes of the Founders, the wishes of the business, the laws of the applicable jurisdictions, and knowledge of the business situation, should be able to draft a Founder’s Agreement in a few hours time.

WHAT PROCESS SHOULD BE EXPECTED TO CREATE A FOUNDER’S AGREEMENT?

There are eight straightforward steps to create a Founder’s Agreement, properly.  They are:

  • Agreement to the concept: Have the Founders and the business executives all agree that a Founder’s Agreement should be created.

  • Decide on the Lawyer: Research into and decide what lawyer to hire for the creation of the Founder’s Agreement.

  • Contemplate the List: The lawyer should draft a series of questions the Founders and the business executives should consider incorporating into the Founder’s Agreement.

  • Meeting Number One: A meeting should be held between the Founders, the business executives, and the lawyer discussing the Founder’s Agreement terms. This can be one meeting where everyone collaborates. This can also be a series of meetings between the lawyer and the individual stake-holders. Consensus is the goal. The parties involved should choose the process most likely to reach that consensus.

  • The First Draft: The lawyer should then create the first draft of the Founder’s Agreement and disseminate that draft to the parties.

  • Meeting Number Two: A second meeting or set of meetings should be held to address any questions, concerns, or edits to the contract.

  • The Second Draft: A second draft of the Founder’s Agreement should be created and disseminated to the parties.

  • Signing the Founder’s Agreement: If all agree, a final, “prettied up” version of the Founder’s Agreement should be created and signed by the parties. Potentially a Notary Public and two witnesses will be needed, depending upon the jurisdiction.

It is time
Draft a Founder's Agreement

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Trial lawyer Matt Hamilton graduated from the University of Missouri in 1995 with Science degrees in Logistics, Marketing, and Business Administration.  Juris Doctor, 1999.