How to Draft a Founders or Co-Founders Agreement?

Introduction

Do you want to start up a business with your relative, friend or co – founder? Have to make decisions regarding the distribution of ownership and responsibilities of each founder? This decision is to be made in writing through the Founders Agreement which prevents future disputes.

If you are entering into business with a co-founder, it can be more exciting and thrilling but on the other side it also involves legal risk and financial decision. Although in the beginning, both parties may trust each other and believe that entering into formal agreement is not crucial, but from time to time when business grows rapidly, the disputes may arise related to profit sharing, investment, obligations, decision making and future direction of the company.

So, the Founders' Agreement serves a clear and concise legal structure to deal with future issues. It records in writing the mutual understanding of both the founders or parties at an early stage and helps ensure that everyone knows their rights and responsibilities.

What is a Founders or Co-Founders Agreement?

A Founders Agreement is a legal contract between the individuals who establish or jointly develop a business. It generally explains:

• Who the founders are.

• Their ownership percentages.

• Their roles and responsibilities.

• Their financial contributions.

• How important decisions will be taken.

• How founder shares will vest.

• Who owns the intellectual property.

• What happens if a founder leaves.

• How disputes will be resolved.

For example, suppose three people start a technology company. One founder develops the software, another manages business operations, and the third handles sales and investment. Without a written agreement, disagreements may later arise about:

• Who owns the software?

• Who should receive how many shares?

• What happens if one founder stops working?

• Can a departing founder keep all their shares?

• Who can make major business decisions?

A Founders Agreement can address these issues before they become disputes.

Why is a Founders Agreement important?

A Founders Agreement helps establish clear expectations between the founders from the beginning.

It Defines Ownership: The agreement can clearly mention each founder's shareholding and ownership rights. This reduces disputes over who owns what percentage of the business.

It Defines Roles and Responsibilities: Every founder can be assigned specific responsibilities. For example:

• CEO – overall management.

• CTO – technology and product development.

• CFO – finance and accounts.

• COO – business operations.

This avoids situations where founders disagree about who is responsible for a particular task.

It Protects Intellectual Property: A startup may develop valuable:

• Software.

• Designs.

• Business models.

• Trademarks.

• Patents.

• Databases.

• Content.

The agreement can clarify that intellectual property developed for the business belongs to the company, subject to the applicable legal and corporate arrangements.

It Regulates Founder Exit: One of the biggest advantages of a Founders' Agreement is that it addresses what happens if a founder:

• Resigns.

• Stop working.

• Becomes incapacitated.

• I want to sell their shares.

• Is removed.

• Dies.

Without clear provisions, a founder's exit can create serious complications for the company.

It Helps Attract Investors: Investors generally want clarity regarding:

• Shareholding.

• Founder commitments.

• Intellectual property ownership.

• Governance.

• Existing contractual obligations.

A properly documented founder relationship can therefore help make the startup legally and commercially more organised.

Is a Founders Agreement Legally Binding?

Yes, a Founders Agreement can be legally binding if it satisfies the requirements of a valid contract and contains enforceable obligations. The agreement should generally comply with the Indian Contract Act, 1872.

The parties should have:

• Legal capacity to contract.

• Free consent.

• A lawful object.

• Lawful consideration, where applicable.

• Clear contractual obligations.

However, a Founders Agreement should also be consistent with the company's constitutional documents and applicable corporate law.

For an incorporated company, certain matters may also need to be reflected in the company's Articles of Association (AoA) and approved through appropriate corporate procedures.

Therefore, simply signing a Founders Agreement does not mean every provision will automatically override the company's constitutional documents or applicable law.

Essential elements of a valid Founders Agreement

Identification of Founders: The agreement should clearly mention:

• Full names of founders.

• Addresses.

• Contact details.

• Professional roles.

• Date of joining the business.

If the business has already been incorporated, its details should also be included.

Business Purpose: The agreement should explain:

• Nature of the business.

• Business objectives.

• Products or services.

• Long-term vision.

• Intended market.

This helps founders remain aligned regarding the direction of the business.

Ownership Structure: The agreement should clearly state:

• Total share capital.

• Shares held by each founder.

• Percentage ownership.

• Rights attached to shares.

• Future dilution arrangements, where applicable.

This is particularly important when outside investors are expected to invest in the company.

Capital Contributions: The agreement should mention what each founder is contributing. This could include:

• Cash.

• Equipment.

• Intellectual property.

• Technology.

• Business contacts.

• Professional expertise.

• Other assets.

The agreement should also specify when and how contributions must be made.

Key clauses every Founders Agreement should include

Details of the Founders: The agreement should clearly identify all founders and their respective roles. This creates certainty about who is participating in the business arrangement.

Business Purpose and Vision: This clause establishes the common objective of the founders. It may explain:

• What the company intends to achieve.

• The products or services it will provide.

• The target market.

• Long-term business goals.

Roles and Responsibilities: Each founder's responsibilities should be clearly defined. For example:

• Founder 1 – Chief Executive Officer, may be responsible for, Business strategy, Investor relations, Overall management.

• Founder 2 – Chief Technology Officer, may handle, Product development, Technology strategy, Technical team.

• Founder 3 – Chief Operating Officer, may manage Daily operations, Vendors, Business processes. Clearly defined roles reduce overlapping responsibilities and internal disputes.

Shareholding and Ownership: The agreement should clearly record the ownership arrangement. The agreement should also address future changes in shareholding due to investment, employee stock options, or further fundraising.

Capital Contributions: The agreement should specify:

• Initial investment.

• Additional funding requirements.

• Contribution deadlines.

• Consequences of failure to contribute.

• Whether founder loans will be provided.

This prevents future disagreements regarding financial responsibilities.

Vesting of Founder Shares: Founder share vesting is an important protection for startups. Under a vesting arrangement, a founder may earn their shares over a specified period rather than receiving unrestricted ownership immediately. For example, the agreement may provide for vesting over four years, subject to the specific terms agreed by the founders.

If a founder leaves early, some unvested shares may be subject to forfeiture or other agreed treatment, subject to applicable law and the company's constitutional documents.

This protects the startup from a situation where a founder leaves shortly after incorporation while retaining a substantial ownership stake.

Decision-Making and Management: The agreement should establish how business decisions will be taken. It may specify:

• Voting rights.

• Board composition.

• Majority decisions.

• Unanimous approval matters.

• Appointment and removal of directors.

• Founder authority.

Important decisions may require special approval, such as:

• Raising substantial debt.

• Issuing new shares.

• Selling major assets.

• Entering a merger.

• Changing the company's main business.

• Acquiring another company.

Intellectual Property Rights: Intellectual property is often one of the most valuable assets of a startup. The agreement should clearly address ownership of software, source code, designs, trademarks, patents, copyright, business processes and databases.

Founders should ensure that intellectual property developed for the business is properly assigned or licensed to the company through appropriate documentation.

Confidentiality: Founders may have access to sensitive information such as:

• Business plans.

• Customer information.

• Financial information.

• Technology.

• Trade secrets.

• Marketing strategies.

A confidentiality clause should restrict unauthorised disclosure or use of such information.

Founder Salary and Benefits: If founders will receive salaries or benefits, the agreement may record the broad understanding regarding:

• Salary.

• Incentives.

• Reimbursement of expenses.

• Bonuses.

• Other benefits.

The actual remuneration may also need to comply with applicable corporate and tax requirements.

Transfer of Shares: The agreement should regulate whether founders can freely transfer their shares. It may contain:

• Right of first refusal.

• Right of first offer.

• Restrictions on transfers.

• Tag-along rights.

• Drag-along rights.

These provisions can help protect the company's ownership structure.

Founder Exit and Termination: The agreement should explain what happens when a founder leaves the business. It should address, resignation, termination, retirement, death, permanent incapacity, voluntary exit, breach of obligations. It should also explain the treatment of the founder's shares after exit.

Non-Compete and Non-Solicitation: Founders may want to restrict certain competitive activities or solicitation of employees and customers.

However, such provisions must be drafted carefully because restrictions on carrying on a profession, trade, or business can raise issues under Section 27 of the Indian Contract Act, 1872.

Therefore, a blanket restriction should not be assumed to be enforceable merely because it has been included in the agreement.

Deadlock Resolution: A deadlock can occur when founders have equal or divided voting power and cannot agree on an important business decision. The agreement can provide mechanisms such as:

• Negotiation.

• Mediation.

• Casting vote in specified circumstances.

• Independent expert determination.

• Buy-out mechanisms.

A clear deadlock mechanism can prevent the startup from becoming paralysed because of an internal disagreement.

Dispute Resolution: The agreement should explain how disputes between founders will be resolved. It may provide for negotiation, mediation, arbitration and court proceedings.

If arbitration is selected, the relevant provisions of the Arbitration and Conciliation Act, 1996 should be considered.

Relevant Indian Laws

Indian Contract Act, 1872: The Indian Contract Act, 1872 is relevant to the contractual relationship between founders. It deals with matters such as consent, consideration, lawful objects, performance, breach, and contractual remedies.

Companies Act, 2013: Where the startup is incorporated as a company, the Companies Act, 2013 becomes important for matters involving:

• Share capital.

• Directors.

• Share transfers.

• Corporate governance.

• Shareholder rights.

• Company management.

The Founders Agreement should be consistent with the company's Articles of Association and applicable provisions of the Act.

Arbitration and Conciliation Act, 1996: Where founders agree to resolve disputes through arbitration, the Arbitration and Conciliation Act, 1996 may govern the arbitration process.

Copyright Act, 1957 and Patents Act, 1970: Where a startup develops software, creative works, inventions, or other intellectual property, applicable intellectual property laws should be considered while drafting ownership and assignment provisions.

Common mistakes while drafting a Founders Agreement

Founders often focus on launching the business and ignore the legal relationship between themselves. This can create serious problems later. Common mistakes include:

• Not recording the agreed shareholding in writing.

• Giving founders equal ownership without considering their actual contributions.

• Failing to define individual roles and responsibilities.

• Not including a founder vesting mechanism.

• Ignoring ownership of intellectual property created before or after incorporation.

• Failing to address what happens when a founder leaves.

• Not providing a mechanism for resolving deadlocks.

• Allowing unrestricted transfer of founder shares.

• Using a broad non-compete clause without considering its enforceability under Indian law.

• Not aligning the Founders' Agreement with the company's Articles of Association.

• Failing to update the agreement when new investors join the company.

• Using a generic online template without considering the startup's specific circumstances.

A properly drafted agreement should address these issues before they become disputes.

Step-by-Step process to draft a founders agreement

Step 1: Identify All Founders

The Founders Agreement should clearly identify all founders by recording their full names, addresses, roles and respective contributions to the business. This ensures that the parties to the agreement are properly identified and that each founder's involvement and responsibilities are clearly documented from the beginning.

Step 2: Decide the Ownership Structure

The founders should clearly agree upon the ownership structure of the business, including each founder's shareholding percentage, number of shares, voting rights and arrangements for future dilution. Clearly documenting these matters helps avoid disputes regarding ownership and control as the business grows or raises additional investment.

Step 3: Define Roles

The agreement should clearly specify the responsibilities of each founder, including their respective roles in management, finance, technology, marketing, operations and investor relations. Clearly allocating responsibilities promotes accountability, avoids overlapping functions and ensures that each founder understands their expected contribution to the business.

Step 4: Record Financial Contributions

The agreement should document the initial financial contribution made by each founder and specify whether additional funding may be required in the future. It should also clarify how further funding will be arranged and whether founders will have any continuing financial obligations towards the business.

Step 5: Establish Vesting

The founders should agree on how their shares will vest over a specified period and clearly state what will happen to unvested shares if a founder leaves the business. Properly documented vesting provisions help protect the company's interests and encourage founders to remain committed to the business.

Step 6: Protect Intellectual Property

The agreement should ensure that intellectual property created or developed for the startup is appropriately assigned or licensed to the company. This may include software, inventions, designs, trademarks, business materials, confidential information and other intellectual property necessary for the company's operations and future growth.

Step 7: Establish Decision-Making Rules

The agreement should clearly establish voting rights and identify important business decisions that require special approval or consent from specific founders. Defining decision-making procedures in advance helps prevent uncertainty regarding management authority and provides a clear framework for making significant business decisions.

Step 8: Create an Exit Mechanism

The agreement should clearly explain the consequences when a founder resigns, is removed, dies or otherwise leaves the business. It should address matters such as transfer of shares, treatment of vested and unvested shares, continuing obligations and any applicable buy-out or exit arrangements.

Step 9: Address Disputes and Deadlocks

The Founders Agreement should provide a clear mechanism for resolving disagreements and management deadlocks between founders. It may establish negotiation, mediation, arbitration or other appropriate dispute-resolution procedures to help resolve conflicts efficiently and minimise disruption to the business.

Step 10: Legal Review

Before execution, the Founders Agreement should be carefully reviewed by a lawyer to ensure that its provisions comply with applicable laws and are consistent with the company's constitutional documents. The review should also confirm that the agreement accurately reflects the founders' commercial understanding and protects their respective rights and obligations.

What happens when a co-founder leaves?

Founder exit is one of the most important matters that should be addressed in advance. The agreement should distinguish between different situations.

Voluntary Exit: If a founder voluntarily resigns, the agreement may provide for:

• Notice period.

• Treatment of vested shares.

• Treatment of unvested shares.

• Buy-back or transfer arrangements, where legally permissible.

• Return of company property.

Founder Removed for Cause: If a founder is removed because of serious misconduct or breach, different consequences may apply depending on the agreement and applicable law.

Death or Permanent Incapacity: The agreement can provide mechanisms for dealing with the founder's shares and succession issues.

Good Leaver and Bad Leaver: Some startup agreements classify departing founders as Good Leavers or Bad Leavers depending on the circumstances of their departure. The treatment of shares may differ between the two categories, subject to applicable law and properly drafted contractual and corporate arrangements.

Rights and Obligations of Founders

A Founders' Agreement should clearly establish the rights and responsibilities of each founder.

Founders Rights May Include:

• Ownership of agreed shares.

• Voting rights.

• Participation in management.

• Access to relevant company information.

• Right to receive agreed remuneration.

• Protection of contractual rights.

• Participation in important corporate decisions.

Founders Obligations May Include:

• Performing assigned duties.

• Protecting confidential information.

• Contributing agreed capital.

• Protecting company property.

• Following corporate decisions.

• Complying with applicable laws.

• Protecting the company's intellectual property.

• Acting in the company's best interests where legally required.

Clearly defining these obligations can reduce conflicts between co-founders.

How Lead India Can Help You?

Our legal team can assist founders and startups with:

• Drafting customised Founders Agreements.

• Reviewing existing agreements.

• Structuring founder shareholding.

• Drafting founder vesting provisions.

• Protecting intellectual property.

• Drafting confidentiality and transfer restrictions.

• Creating founder exit mechanisms.

• Advising on deadlock resolution.

• Aligning the agreement with the company's Articles of Association.

• Drafting or reviewing Shareholders' Agreements.

• Assisting with founder disputes and negotiations.

Professional legal advice is particularly important where the startup has significant intellectual property, multiple founders, substantial investment, or plans to raise external funding.

Conclusion

A Founders' or Co-Founders' Agreement provides a strong legal foundation for a startup by clearly defining ownership, responsibilities, decision-making powers, intellectual property rights, founder vesting, and exit arrangements. While founders may begin their business relationship on the basis of trust, written legal terms become extremely important as the business grows. A carefully drafted agreement can reduce misunderstandings, protect the startup, and provide a clear mechanism for dealing with difficult situations.