FOUNDERS AGREEMENTS – WHY DOES ONE NEED THEM? - Professional Services Tailored for Businesses

WHAT FACEBOOK’S ZUCKERBERG TEACHES US ABOUT FOUNDERS AGREEMENTS

Facebook’s Mark Zuckerberg faced at least a few lawsuits in the initial years that were driven by missing Agreements, all of which resulted in rather expensive multi-million dollar settlements. The most notable of which were against The Winklevoss Twins, founders of the site, ConnectU due to the lack of a formal written contact and against Eduardo Saverin due to the lack of vigorous anti-dilution protections. In the former case, the lack of a Founder’s Agreement defining Zuckerberg’s role wasn’t in place nor were the IP rights defined. The case was eventually settled out of court for $65 Million in 2008. In the latter case the foundational Agreement lacked effective anti-dilution clauses as well as suitable exit clauses for the non-working Founder. This case was settled out of court in 2009 for a 4-5% stake in Facebook as well as official recognition for Saverin as a co-founder.

Why Are Founders Agreements Essential

Noam Wasserman, a business professor of note stated that 65% of startups fail due to conflict among co-founders. While a rapid analysis of the collapse of start-ups won’t throw up a lack of Founders’ Agreements as the cause, a more in-depth analysis would frequently trace the said collapses back to the lack of necessary protections in the various Agreements.

A Founders’ Agreement would be a legally binding contract that defines the business relationship between them and serves as a rule book to establish clear expectations. Besides providing legal protections for various eventualities, for the Founders, it prevents conflicts and for Investors, it builds confidence.

Issues Addressed

A full-bodied Agreement would typically address the following issues:

Defining Roles and responsibilities
Neutralize conflicts between Founders
Prevent operational confusion and establish authority
Schedule vesting of Shares
IP Assignment ensures Protection
·Manage effectively Exit strategies, Departures and Wind-downs

The Deeper Why

Defining Roles and responsibilities

Facebook survived the lack of a Founder’s Agreement and ineffective clauses to go on and become a success story. However, not all start-ups have been so fortunate. Other start-ups like Metaversity, for instance, due to a conflict between the Founders and lacking the necessary clauses in an Agreement between them, drove the company into the ground. The Facebook experience teaches us that a Founders’ Agreement would help in defining Roles and responsibilities and Exit strategies.

Neutralize conflicts between Founders

What starts off as great ideas shared at a pub, for instance or over a coffee, later develops into viable business ideas that could potentially earn lucrative profits. Often start-ups’ initial investors and at times their biggest investors are family and friends. Founders similarly, often begin as friends and or during the course of building the start-up develop friendships. However, to rely on the relationships ironing out the creases in the Company would inevitably result in tearing the Company itself apart. A good Founders Agreement would neutralize conflicts between Founders while at the same time protects personal relationships.

Prevent operational confusion and establish authority

At times, one idea can result in several different visions. Down the line, these differing visions if not aligned, will affect the Company catastrophically. Another significant case would be that of Housing.com where the lack of a clear Agreement on the roles played by the founders and their exit rights resulted in a publicly acrimonious and unpleasant departure of 9 out of the 12 founders and the firing of the CEO. The Founders Agreement would prevent operational confusion, establish authority and enable Performance tracking.

Schedule vesting of Shares

The Viral Fever, where Prashant Raj sued co-founder Arunabh Kumar, is an example of oral promises not materializing and therein resulting in the creation of “Dead Equity”. This case brings out the challenges that arise when, in the absence of a written Founders Agreement, the founders fall out and one founder seeks an exit or compensation. The exit of one Founder with their unearned shares results in insufficient equity being available to motivate other founders, employees nor, most importantly, Investors. A Founders’ Agreement would be able to schedule vesting to ensure that their unearned shares would return to the Company allowing it to continue to be interesting to Investors.

IP Assignment ensures Protection

In many startups today, its Intellectual Property (IP) is almost entirely the startups value. The Startup’s code, its Brand value and or its trade secrets makeup its DNA. Bluegape was a funded startup that was forced to shut down primarily due to Copyright issues and legal non-compliance. Founders’ Agreements would ensure that the IP which, in many jurisdictions belongs to the Creator, is immediately transferred to the Company on the Creator’s exit. It could force an immediate transfer of all past and future work to the company entity, thereby protecting the Company from a potential situation where if the Creator was to leave on bad terms, the said Creator would technically own the ‘DNA’ of the Company and could sue the Company for its use.

Manage effectively Exit strategies, Departures and Wind-downs

A Founders’ Agreement would be able to help manage Departures and Wind-downs. Structured Exit Clauses would spell out what exactly happens when a Founders leaves or is removed for misconduct, for instance. The founders of Zipcar split the Company’s equity 50/50% between themselves. They made bold assumptions about expectations and time commitments, none of which got documented. Questions about contributions eventually led to a paralysing tension that brought the venture to its knees.

Founders’ Agreements provide an early Safety net to Prevent Unseen Failures

Facebook and several other examples illustrated above teach us that when founders fail to document their relationship, read as not having Founders’ Agreements, and all one is forced to rely on are “implied contracts,” oral testimony, and or fragmented communications (like emails or instant messages) to determine the business relationship, it results in multi-million-dollar settlements or the dissolution of the company.

A Founders’ Agreement provides a safety net and employs safeguards to ensure that a business is protected. It is an agreement that spells out each co-Founder’s rights and duties, helping to protect everyone’s interests. It rewards Co-Founders for actual contributions and facilitates the strengthening of Company by weaving together each Founders perspective and exchange of ideas.

Conclusion

The Facebook story and every case above illustrate the same lesson: when founders fail to document their relationship in a formal agreement, disputes are ultimately resolved through implied contracts, oral testimony, or fragmented communications at enormous financial and reputational cost.

A Founders’ Agreement safety net one that spells out each co-founder’s rights and duties, rewards actual contributions through structured vesting, protects relationships from turning acrimonious, and signals professionalism to investors. Whether you’re registering as a Private Limited Company or an LLP, the Founders’ Agreement should be one of the first documents you put in place before the first line of code is written, before the first rupee is spent.

The Startup Zone helps early-stage startups draft, review, and formalise all foundational legal documents including Founders’ Agreements, IP assignments, and shareholder agreements.

Author Profile

Adv. Adrian Phillips

LL.B., LL.M. Criminology and Environmental Law

Partner at ASKD We Resolve Legal Associates in Mumbai

With 18 years of extensive experience, Adv. Adrian Phillips specializes in legal consultancy for startups, NGOs, and state departments.

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The StartUp Zone (StartUp Zone Financial Planning and Advisories Private Limited) promotion on Google Ads focuses on providing consultancy services through our private portal (https://thestartupzone.in/), and our targeting of keywords related to government documents and services is incidental to understanding client needs, rather than promoting such documents or services directly. Our portal (https://thestartupzone.in/) does not represent any affiliation or association with any government authority or body. We emphasize to our users that we are a private company managing this website, and any fees collected are for consultancy services rendered.