What is a Founder’s Agreement
And Why It’s Essential Before You Start Working On Your Startup
When you start a venture with other people, you have to decide how to split the ownership of the company.
You need to agree on who will own what part of the company and in what proportions.
You need to decide how to make decisions about the company, such as what decisions require everyone’s agreement and what decisions only require majority or supermajority agreement.
This agreement is known as a “Founders Agreement.” It’s like a prenuptial agreement for a marriage, but instead of defining who gets what in case of divorce, it defines how the company will be owned and operated.
All these happen before you incorporate the company.
Why is a Founder’s Agreement important?
Because, when you incorporate your company, the law assumes that all of the founders own equal shares of the company.
You can challenge this assumption by creating a Founders Agreement that says otherwise.
This will make it much easier to raise money from investors and negotiate with potential acquirers down the road.
It’s easy to assume that you’ll be able to come up with a fair allocation of shares later on, but it’s very hard to do so in practice.
When you’re starting out, you don’t know how much value each founder will create for the company or how hard each founder will work.
So how can you fairly allocate shares now? And even if you could do so, why would you want to? W
hy not let the founders take on different levels of risk and reward based on their contributions?
Here are some examples of why a Founder’s Agreement is important:
When 2 co-founders start a company together and one decides to leave after 1 year, should he/she get 1/2 or 1/3 of his/her original ownership back?
If one founder wants to take his stake in cash instead of stock, should he get his pro-rata share of the company’s cash or his pro-rata share of the company’s stock?
If a founder wants to bring in another founder to the company, how should that be handled?
You can think of many more scenarios, but hopefully, you get the point.
Without a Founder’s Agreement, it will be hard to know what to do in these situations. With a Founder’s Agreement, it will be much easier.
How much time should you spend on creating a Founder’s Agreement?
The answer depends on how much risk you want to take on.
If you’re willing to take on a lot of risks, then it’s not worth spending too much time creating a Founder’s Agreement.
It will be hard to create an agreement that is fair and makes sense in every situation. You’ll probably end up arguing about it anyway, so why not just skip the argument and start the company without one?
If you’re not willing to take on a lot of risks, then it’s worth spending a lot of time creating a Founder’s Agreement.
The more time you spend on it, the more likely you are to end up with an agreement that makes sense in every situation.
And if you can’t come up with an agreement that makes sense in every situation, then maybe you shouldn’t start the company in the first place.
My suggestion is to spend somewhere between 1 hour and 10 hours creating your Founder’s Agreement.
That way, if your venture fails or becomes successful but stays small for a long time, then you won’t have wasted too much time trying to create something that will never be used.
But if your venture does become successful quickly, then at least you’ll have something useful to show for your time.
How to create a Founder’s Agreement:
1. Decide how you want to split the ownership of the company.
What percentage of the company do you want each founder to own? Do you want any founder to own more than 50%?
If so, what would happen if that founder wanted to leave the company? Do you want one founder to own less than 1%?
If so, what happens if that founder leaves the company and then wants to come back later on?
2. Decide how you want to make decisions about the company.
Who needs to agree on decisions, and what is the voting threshold for each type of decision?
For example, should all founders need to agree on major strategic decisions, or only a majority of them? Or should major strategic decisions require supermajority agreement (like 2/3 or 3/4)?
How many founders should be able to start spending money from the company’s bank account without getting approval from everyone else first?
Is it okay for a single founder to sell his/her stake in the company without getting approval from everyone else first?
What happens if there is a dispute about a decision made by only one or two founders, but no one else knows about it?
3. Decide how you want to add or remove founders from the company.
Do you want to add or remove founders by unanimous agreement, or by majority agreement?
If you need a unanimous agreement, then what happens if someone disagrees? Do you want any founder to be able to remove another founder from the company without getting approval from everyone else first?
What happens if a founder leaves the company and then wants to come back later on?
What happens if a founder wants to bring in another founder, but the other founders don’t agree with that decision?
4. Decide how you want to divide up shares of the company between founders.
Do you want all of the shares of the company to be issued as “class A” shares that are equal for all of the founders, or do you want some of them to be issued as “class B” shares that have different rights and/or preferences than class A shares?
If some of them are class B shares, then what should those rights and/or preferences be?
Do you want any of them to be issued as “class C” shares that have even more different rights and/or preferences than class B shares? If so, what should those rights and/or preferences be?
5. Decide how you want to handle a merger or acquisition of the company.
What happens if the company gets acquired? Do you want to get paid in cash, stock, or some combination of both?
What happens if the company gets merged with another company? Do you want to get paid in cash, stock, or some combination of both?
If you get paid in stock, then what happens if the value of that stock later goes down (or goes up)? If you get paid in cash, then what happens if the value of that cash later goes down (or goes up)?
Do you want to get paid for your shares immediately after a merger or acquisition, or do you want to hold onto your shares for a while before selling them?
6. Sign and date it.
If two founders have already started working together on a project and they decide to incorporate their company soon after that, then they can use this Founder’s Agreement as their very first agreement.
If two founders have never met each other before but they decide to start a company together after talking on the phone or via email for several weeks about their idea for a new startup, then they can use this Founder’s Agreement as their very first agreement.
If two founders have already started working together on a project and they decide to incorporate their company several months after that, then they can use this Founder’s Agreement as their second agreement.
If two founders have never met each other before but they decide to start a company together after talking on the phone or via email for several weeks about their idea for a new startup, then they can use this Founder’s Agreement as their second agreement.
The above 6 steps will help you create your own custom-made Founder’s Agreement.
However, if you don’t want to go through all of that trouble, then there are two alternative options:
Option 1: Buy a pre-made Founder’s Agreement that can be found online
Option 2: Hire an attorney to create your custom-made Founder’s Agreement for you.
About the Author
I am the Founder of Cudy Technologies (www.cudy.co), a full-stack EdTech startup helping teachers and students learn better. I am also a mentor and angel investor in other Startups of my other interests (Proptech, Fintech, HRtech, Ride-hailing, C2C marketplaces, and SaaS). You can also find me on Cudy for early-stage Startup Founder mentorship and advice.
You can connect with me on Linkedin (https://www.linkedin.com/in/alexanderlhk) and let me know that you are a reader of my Medium posts in your invitation message.
