As a company scales, one of the most important things co-founders can do is formalize their relationship. Yet Forbes lists the absence of a founders’ agreement among the top 10 legal mistakes made by startups. And poorly-constructed agreements lead to founder conflict which, according to Y-Combinator co-founder Paul Graham, is one of the most fatal mistakes that kill startups. Where do most agreements go wrong? What key terms should your founders’ agreement (FA) include?
We talked to a range of leading entrepreneurs about their personal experience with founders’ agreements. Some successfully operated without formal, written founders’ agreements. Others eagerly established formal agreements at the outset that ended disastrously while others carefully crafted agreements over time that have helped keep their company on course. We can’t give you a precise rule for creating a founders’ agreement and some co-founder conflict is inevitable. But we can provide a framework that will help you avoid common mistakes and equip you to handle conflict.
When co-founders possess distinct individual skills, roles can fall into place organically and you may be tempted to forgo writing a founders’ agreement. For instance, when three co-founders launched BlackBuck in 2015, they divided roles according to skillset. Each agreed to accept a functional lead that aligned with their skills: fundraising, operations, and sales. But many co-founders have a significant overlap in skills and expectations. Addressing key terms—roles and responsibilities—in your founders’ agreement becomes critical.
BlackBuck’s co-founders decided not to write a formal agreement at the outset. However, they took the time to clearly establish expectations about responsibilities and role divisions. Alignment on those decisions enabled their startup to scale exponentially. Between July and December 2015, they expanded from three locations with three clients to 54 cities with 50 clients and the team grew from 35 employees to 250. In less than two years, they developed a technological platform and built a network that completely revolutionized India’s trucking industry. By the end of 2018, BlackBuck grew to over 2,000 locations, serving 10,000+ clients.
The decision to forgo a written founders’ agreement worked for BlackBuck because they shared complementary expectations and verbalized their agreement about roles and responsibilities.
BlackBuck’s founders also unanimously agreed upon titles and who would serve as CEO. That scenario is relatively rare. Often, when two or more co-founders exist, each expects to become CEO. Planning to discuss your expectations for titles and general responsibilities with your co-founder early can mitigate future conflict.
Inevitably, during early stages—when uncertainty abounds—and scaling—where needs change rapidly—titles and roles may shift. You can stipulate that roles will be reevaluated periodically, such as every six months, and, if necessary, redefine titles and roles to reflect changing needs.
How much compensation should each co-founder receive? Most founders ask themselves, “what percentage of ownership will I get in return for what I am putting into this venture?” Wasserman discovered that 73% of founding teams split equity within a month of founding. But when crafting a founders’ agreement, equity is the last item that you should discuss.
Most founders opt to divide equity equally or calculate a percentage of equity split based on the contributions each co-founder makes. Many approaches and methods for calculating equity exist. But calculating percentages is highly subjective. Calculations are often based on the founders’ past contributions—which many overvalue—and expected future contributions—which are impossible to accurately predict.
While your FA can cover the allocation of equity, you also have the option of making the equity split a separate legally binding document. Read more about deciding how to allocate equity in How To Think About Equity Splits. When discussing equity and decision rights, resist the common temptation to conflate the two.
Some founders have a strong network they are willing to share that would increase the chances of a company succeeding. Others feel reluctant to share their network initially, while they’re unsure of the future success of the company. For instance, when launching Endeavor, a nonprofit that promotes the power of entrepreneurship, co-founders decided to split equity equally. However, when the company developed in a way that differed from the original vision, the co-founder who disagreed with the venture’s new direction, refused to share his network. Without a provision about founders’ networks in an FA, a founder can continue to retain original equity in such a case.
Your founders’ agreement should list if either founder contributed personal funds to the venture and describe the terms for capital usage. To demonstrate commitment and protect valuable business information, your FA should also include a standard confidentiality clause.
Even with a thoughtfully crafted founders’ agreement, unpredictable issues will arise. Your FA can provide provisions that help establish a process for dealing with unexpected scenarios, such as if a partner leaves. Founders often don’t feel the need for contingency provisions, but at a minimum, including a vesting period for all co-founders can protect your startup and your relationship.
Instead of receiving equity rights instantaneously, vesting defines the criteria co-founders must meet to earn their equity. Commonly, vesting stipulates that founders must either work for a set period of time or meet certain milestones before their equity becomes available. Vesting provisions help ensure that co-founders will remain actively involved in and committed to the startup. The most common time-based vesting term occurs quarterly over four years, with a one year cliff. That means that the vesting schedule will not be enforced for the first year. Most founders opt to include a time-based vesting schedule in their FAs, despite the fact that time-based vesting only measures the quantity of time, not the quality of work.
A founders’ agreement serves several important functions. On the most basic level, it establishes the roles, responsibilities, and rights of founders. It gives co-founders the opportunity to negotiate a shared vision. Perhaps most importantly, it provides a way to resolve future contentious issues. Many helpful online resources exist to help you get started on drafting a founders’ agreement with standard terms and provisions. But don’t rush the process. Plan to have ongoing conversations and document your expectations in writing, especially if areas exist where you and your co-founder disagree.
[] What are the titles of each founder?
[] Do you have clearly defined responsibilities for each role?
[] Have you created limits for roles?
[] How will you allow for change as founders’ roles change over time?
[] Who will decide what?
[] What is the time limit for decision making?
[] How will you handle deadlock?
[] By what method will you reach consensus when making important decisions?
[] Which decisions can be made by a single person, and which need consensus by both/ all founders?
[] Did you separate equity from decision rights?
[] Who will represent the company on the Board?
[] Will founders who don’t have Board representation receive observer rights?
[] How will you allocate equity?
[] Did you include time-based or milestone-based vesting terms?
[] What happens if a founder leaves or is asked to leave?
[] If a founder leaves, do other founders have the right to buy unvested shares or do these go back to the common pool?
[] What happens if a founder wants to sell part of his or her shares?
[] How will you handle the acquisition or sale of the company?
[] Will you create an option pool to attract new hires or give additional grants to the existing team? If so, how much of the equity will you reserve for that?
[] How much time will each founder commit to the startup and for what duration? Did you specify the number of hours that comprise a full-time?
[] What is each founders’ obligation to the company, in light of future external opportunities that could conflict with current roles and expectations?
[] Did you include an IP provision?
[] What is each founder’s financial obligation to the company?
[] Did you record any capital contributions by a founder, and terms of usage?
[] Will founders share networks and connections?
Shikhar Ghosh is a serial entrepreneur, angel investor, and Professor of Management Practice at HBS. Named one of the "Best Entrepreneurs in the US," by Businessweek, Ghosh has led some most innovative tech-based companies in the US and advised hundreds of entrepreneurs.
The Arthur Rock Center for Entrepreneurship is the champion for entrepreneurship education and training for Harvard Business School.
