Key legal pitfalls of starting up: Agreeing the deal with your co-founders

05 December 2017. Published by Charles Buckworth, Partner

Securing an early agreement with your start-up co-founders can prevent costly disagreements in the future.

When you start out in business (much like when you start out in marriage if we can use that analogy) things are normally, well . . . . warm and fuzzy.  There is normally a group of excited and like-minded people who have a great idea and want to make it happen.  

As lawyers, we always seek to consider the best and worse-case scenarios (and the scenarios in-between).   This gives us something of a (possibly unfair) reputation as pessimists.  But when starting out with co-founders, business partners, investors or collaborators thinking to the future when the relationship may not be so rosy is an advisable thing to do.  Failing to do so can end-up in prolonged and expensive litigation around what was and was not agreed between founders (particularly if the start-up is a success and substantial amounts of money are involved).  This is not only expensive but is also a distraction to the business (and in some cases can be fatal to the investment of one or more co-founder).  History is littered with examples of disputes between co-founders and those involved in early stage businesses.  The numerous court cases around Facebook and Snapchat are cases in-point.  

Agreeing a firm basis on which to conduct your business with your co-founders and/or investors is therefore essential and will help to get all the issues out into the open at an early stage so that they can be worked through and agreed when relations are good and everyone is driving in the same direction.  This helps to avoid misunderstandings/people feeling unfairly treated later on.  

Some examples of issues to consider and agree include:

  • What are the roles and responsibilities of each founder?  What time, monetary or other commitment should each founder have to provide?  What are their salary entitlements?  What will be the dividend policy?   -  One scenario which is far from uncommon is where one co-founder has substantial equity but becomes disengaged from the business leaving the remaining founders carrying what they consider to be a "dead weight"

  • What type of entity should be used for the business (for example, a limited company or a limited liability partnership?

  • If the start-up is a company, what percentage ownership should each founder/investor have?  What control/protection (if any) should founders/investors have against dilution of their share capital, issuance of new shares etc.

  • How will the board be composed, how frequently should it meet and what should its quorum be?

  • What matters should be "reserved matters" (i.e. should require unanimous/majority approval in order to be implemented) for co-founders/investors?  Some examples include issuance of shares, sale of intellectual property, entering into substantial debt obligations etc.

  • How will the company be funded?  Will co-founders/investors be under an obligation to fund the business up to a certain amount or will be funding be on a case-by-case basis?  Will funding be on an equity or loan basis? What further funding rounds are anticipated, over what timeframe and from what sources? 

  • Will any employees be incentivised through the grant of shares? Should there be different classes of shares with different rights attaching to them?

  • What are the founders expectations regarding the length of their investment/commitment to the new business? What ability do founders have to exit the business and sell their shares? How will good leaver / bad leaver provisions operate?

  • Who is in charge of the day-to-day running of the business?  How will decisions be made?  How will a business plan be agreed and updated? What happens if there is deadlock and the founders / other shareholders cannot agree on a way forward?  How will disputes be settled?

  • How will a sale of the business be agreed? What if some founders/shareholders want to sell but others do not?

  • What non-competes should be included to prevent co-founders competing with the business?

  • Confidentiality obligations to prevent co-founders disclosing confidential information other than in the course of the start-up's business.

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