TIPS FOR A SUCCESSFUL STARTUP FOUNDERS’ AGREEMENT
By Adv Ido Shomrony, Hi-tech & VC Practice
Your startup is taking shape: the promising idea has been clinched, partners found and allied, and you are now at the point of formalizing the relationship among the founders themselves, and between the founders and the company. Many agreements like this are signed every day, but however trivial they may seem, they should not be taken lightly. Points of agreement that were not thoroughly examined, or subjects that should have been included in the agreement but were omitted, may lead to problematic outcomes and give rise to disputes. The following tips set forth issues that should be addressed in the founders’ agreement, including those that merit special attention and thought.
An “appropriate” allocation of equity should express the alignment of expectations between the founders regarding their contribution to the company – both the contribution they have made until that point and the contribution that they will make from the moment the company is established and thereafter. The importance of this contribution is expressed in the unique added value that each founder delivers to the company – i.e. quality, and also in terms of the time invested (quantity).
The allocation of equity should also be taken advantage of in order to tie up any “loose ends” regarding parties who were involved in the venture until this point (whether by giving them shares or options), even if only for the sake of preventing being faced with future unrealistic, exaggerated demands for equity, especially those of the kind you did not take into account when making the initial distribution, from people who were involved and had helped the venture during the very first steps.
Assigning job titles
Beyond the obvious need to staff positions and assign responsibilities (COO, CTO, CFO, CEO or others), there are additional issues that need to be dealt with while aligning expectations, which include:
Defining the job scope of each of the founders, for example, will it be increased gradually and subject to milestones (e.g. an outside investment), as a function, among other things, of the founders’ earning capacity until a tangible return for their employment in the company is received.
This is directly related to the question of the nature of employment conditions in the company; will or will there not be any compensation until significant funds have been raised, or (if applicable), operations begin to generate income. Expectations regarding the principles of the employment contract that will be signed in due course should be mentioned in the founders agreement.
Are the founders presently employed? Do they have permission from their current employer to work in the venture at the same time? A founder’s employment by the startup (to date as well as in the future) must be properly anchored in terms of non-competition (for example, the use of work equipment or activities for the startup on account of the employer’s work time may indicate a possible legal problem) and intellectual property rights in regard to both current and previous employers.
These issues must be properly dealt with and settled in general, and even more so when the people in question are connected to the academic world, research institutes, medical institutions or government / public institutions and bodies (the rules in place in these entities sometimes also apply to people who have retired, during a certain “cooling-off period”, as well as to people on sabbatical or unpaid leave, etc., whether they are faculty members, employees (including civil servants) or even students, for example those who are involved in activities in research labs as part of the researcher’s team).
The reason why the proper arrangement of this issue is even more important when institutions of these kinds are involved is the concern that the IP rules of the institution, which apply to the founder who is in contact with it, may determine that under certain conditions intellectual property rights applying to developments or inventions created by that founder, alone or with others, in the course of his work or employment or studies or research activities, etc., belong to the institution, unless the founder has received the institution’s consent, in advance and in writing. In most cases, consent of this kind is made conditional on no use being made of infrastructure or equipment belonging to the institution in connection with a development of this kind, as well as on the absence of any link between the nature of the development and the area of occupation in the institution.
In most cases, the founders’ investment (at least the majority of it) does not take the form of money, but rather their energy and skills.
This being the case, it is wise to prevent a case where a founder is fully entitled to shares despite having left the company “prematurely”, before having had the time to make the entire contribution expected of him in return for his right to these shares.
This is achieved by defining a mechanism of gradual vesting over predefined periods of continuous service in the company, with shares that have not vested being subject to a repurchase right, free of charge, by the active founders (pro rata to their relative holdings in the company). The mechanism may be linear, or not (if, for example, we take quarterly vesting over a two-year period, a one year “cliff” may be set, during which no equity shall vest, but after which half of such shares shall be released from repurchase right, and thereafter, throughout the second year, the second half of the shares vests in four equal tranches, one at the end of each quarter).
When considering the quantity of shares that will be subject repurchase, thought should be given to the past, i.e. when each of the founders began to contribute to the venture before the company was established, as an entrepreneur who has contributed a year of his energies and activities may be treated differently than a person who joined the project shortly before the company was founded. The difference between them could be expressed by determining that the former will have more shares that have vested on day 1 (i.e. fewer shares that are subject to repurchase).
It is important to be aware of the possibility that the income tax authorities may, in certain circumstances, view the subjecting of shares to vesting as if they were options (from the tax aspect). Therefore, the allotment of shares that are subjected to a vesting schedule, which are not allotted under an approved option plan according to section 102 of the Income Tax Ordinance, and are deposited with a trustee, may involve tax exposure (noting that an allotment of shares under a “102 plan” is possible for employees and officeholders, to whom less than 10% is allotted, and not for independent consultants or controlling shareholders).
Funding the company by the founders
“Record keeping” of past expenses – insofar as they are not significant – is not recommended, if only for the sake of simplicity and cleanliness vis-à-vis prospective investors, and this also conveys a message to these investors that the founders believe in the company and have expressed this belief by investing their own money in it. However, if significant amounts are at issue, which justify treatment as a shareholders’ loan, and the founders indeed wish to view it as such (bearing in mind that when the investment agreement is on the agenda and the subject is discussed, it is likely that if a significant sum is at issue the investors may not be willing to “finance” this return to the founders through their investment), then general statements are not enough and the conditions, including the repayment date, under which terms (a positive cash flow over a certain period?), over how much time, before a dividend is distributed, etc., must be defined.
With respect to funding – are the founders interested in internally financing a specific initial sum needed to get the company started? Will the board be entitled to decide in the future on internal financing, in the framework of which the shareholdings of those who choose not to participate will be diluted?
Appointing directors and decision making
Will each of the founders have the right to appoint directors?
We tend to liken a situation in which there are two founders who are equally represented on the board and in the meeting of shareholders (50/50) to a marriage: if they don’t get along, they will have to get together to solve the problems or get a divorce, because substantial/habitual differences of opinion will lead to a deadlock and stagnation. Although there are various mechanisms for resolving deadlocks, such as “buy me buy you” (BMBY), firstly, mechanisms such as these have inherent drawbacks (BMBY, for example, is biased toward the shareholder with greater financial resources), and secondly, as we see it, parties who are headed for marriage need to believe in their ability to solve and overcome disputes, or, alternatively, to find a logical way to separate, and not define separation mechanisms in advance, the very existence of which may serve as a catalyst and incentive for separation.
If the number of board members is uneven and the division of shares in the general meeting is unequal, thought should be given to specific issues in which respect accepting the majority decision is not enough. Are there matters on which we would like a requirement for an unanimous decision by all founders? Or perhaps any other qualified majority? These matters may, for example, include investment in the company, engagement in a strategic agreement, a change of business area, or a change of signature rights.
As for signature rights, trivial as the subject may be, thought should be given to refraining from devising mechanisms that are over-burdensome and will hamper the day-to-day management of the company in terms of its ongoing needs; for example, so that the company will not find itself in a situation where due to a signatory being on reserve duty or out of the country on business or vacation the company is unable to pay expenses which are not substantial, but are necessary for its day-to-day operation.
Key conditions in founders’ agreements relating to share transfers and allotments
The terms and conditions one generally finds in founders’ agreements are listed below:
No sale: A provision prescribing a minimum period in which the transfer of shares is prohibited. Its purpose is to make sure that for a minimum period you won’t find yourself “married” to another person, who is not the founder with whom you planned and expected to be in a shareholder relationship in a jointly owned company, at least for a certain period of time. The idea is to keep the equity in the company and not open it to outsiders. It is important to provide for an exception, whereby a transfer to certain permitted transferees, defined in advance, is possible (classic transferees are first-degree relatives or a company owned by that same founder).
Right of first refusal: Right of first refusal between shareholders upon a sale of shares, also designed to keep the equity in the company and not open it to outsiders. The right is usually granted pro rata (i.e., in proportion to each shareholder’s holdings in the company’s equity). In this context, thought should be given to also including the possibility, according to the circumstances, of permitted over-allotment, which means giving the founders an opportunity to also buy (pro rata) the stake of a founder who has chosen to not to buy.
Co-sale the right (among shareholders) to join a sale of shares. Also, usually, granted pro rata.
Preemptive right: A privilege extended by the company to its shareholders upon allotments, also designed not to open the equity of the company to outsiders and to prevent dilution. Here too, the possibility of over-allotment should be considered, as well as the possibility of an all-or-nothing stipulation, meaning that if the shareholders do not commit to buying all of the securities offered, the company will be permitted to sell them to a designated third party (which is in the company’s interest, as it is highly possible that the third party will not be interested in buying only part of the shares, and consequently the entire deal will run aground if the shareholders buy only part of them).
Beyond the standard provisions that need to be defined on the matter, special attention should be given to the question whether the specific assignment of certain IP is necessary (for example, is there a patent that is owned by one of the founders before the establishment of the company) (noting that assignments such as this give rise to tax issues, and this must be considered in advance), for caution’s sake, the necessary steps should be taken with respect to former and present employers (not only in regard to the public/government/medical/academic/research institute sectors), as well as those necessary to tie up loose ends with all contributors who were involved in or contributed to the development of the startup’s intellectual property and who are not founders.
Non-disclosure and non-competition
These are standard provisions. It is important to be aware of the limitations imposed by the court in Israel on non-competition, its duration, and the legitimacy of its terms and conditions. One needs to be aware of the distinction between a non-competition undertaking made by a founder in his capacity as a shareholder, in which case the court will more inclined to accept the legitimacy of the non-competition requirements, as opposed to such an undertaking by the founder in his capacity as an employee, to which the limitations imposed by the court in this context usually refer. Additionally, it is important, for example, to make sure that the period of the undertaking is reasonable, and to review the area of occupation to which the non-competition provision refers. Moreover, if the founder is expected to also engage with the company as an employee, it is important to remember to make sure in the future that these provisions will receive specific attention, in each case on an individual basis, according to the employee’s identity, his position, etc., when the time arrives to engage in an employment contract with him, that the contract contains specific provisions that will be drafted by a professional labor lawyer who is well versed in the subject (for example, in respect of special consideration, waiver of service inventions, etc.). We would like to point out that the existence of a non-competition stipulation in itself, apart from the question of the ability to enforce it and to what extent, is of significance if only from the psychological aspect of the founder who knows that he is subject to certain obligations.
Issues related to Articles of Association
As mentioned, some of the provisions in the founders’ agreement are usually governed by the company’s Articles of Association as they are provisions between the company and its shareholders (“AOA provisions”) and not only between the founders themselves, and are expected to change in the framework of investment agreements with outside investors from whom funds will be raised (for example, preemptive right provisions are such, while the provisions regarding the allocation of equity upon the company’s establishment will not change). Consequently, to preclude the need to amend the agreement in the future, it is desirable, in the first stage, to define provisions in the agreement next to these “AOA” provisions, which allow for flexibility in an investment round and do not necessitate that the agreement be modified.
The information presented above does not constitute legal advice nor is it a substitute for legal advice nor advice of any kind, and it does not constitute legal treatment nor a substitute for professional legal or other treatment, which takes into consideration each case on its own merit.