Why You Need A Founders Agreement

Last updated: 15 July 2020

Estimated reading time: 10 minutes

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Starting a new business is an incredibly exciting time. You’ve nailed your business idea, found some partners with complementary skill-sets and ambitions, done your market research and you’re dying to press ‘enter’ and dive into your adventure. Now is the perfect time to sit down with your co-founders and hammer out your business strategy, what you expect of each other, and what your rights and responsibilities will be.  

You may not have got as far as deciding what legal form you want your business to take, whether that be a limited company or a partnership.  Even so, it’s really important to get some basic details down on paper and agreed between you right at the start – and that’s where a founders agreement comes in. We’ll show you what a founders agreement is, what should go into one, and how this agreement is different from documents such as shareholders’ agreements and partnership agreements.

Jump to:

  1. What is a founders’ agreement?
  2. Why do you need a founders’ agreement?
  3. What should a comprehensive founders’ agreement consist of?
    1. The business
    2. Business culture
    3. The co-founders
    4. Length of the agreement, amendment and termination
    5. Jobs and decision-making
    6. Assets and ownership
    7. Secrecy and right to compete
    8. Next steps
  4. What about a founder exit agreement?
  5. Should you also consider drafting a founder IPR assignment agreement?
  6. Should the agreement change pre/post incorporation?

What is a founders’ agreement?

A founders agreement is a relatively informal document between one or more people that describes their intentions in respect to the business they’re building together. It’s generally the precursor to formal agreements like shareholders’ agreements and partnership deeds. Looking more like a statement of intention than a binding contract, when you draw up a  founders agreement you can front-up issues like who does which job, what ownership shares you should each have, and what you are bringing to the table like cash, assets or special skills.

While founders agreements are optional, we recommend that every start-up has one as insurance against issues and problems that can arise once you’ve proved your business model and are ready to move to the next stage and form your company or partnership.

Here are some areas a founders agreement can cover:

  • What sector you’ll be operating in, and what your business will be
  • What each of you will be bringing to the business
  • What to do if you fall out
  • What if one of you wants to leave, or another person wants to join
  • What to do if you abandon the idea, and either of you wants to set up a similar business

Because a founders agreement is relatively informal, it can easily be changed as you go along and as the business idea develops. Also, having a founders agreement in place demonstrates to potential investors that you are professional and organised, serious about your business, and knowledgeable about the pitfalls that can occur. 

Why do you need a founders’ agreement?

Here are some of the main reasons why it’s a sensible idea to have a founders’ agreement:

  • It makes you face up to some of the tricky issues. Asking yourself tough questions early on helps avoid misunderstandings and potential areas of conflict between you.
  • Because, let’s face it, details can be boring. Sitting down and working through the nitty-gritty will give you a good idea of whether you and your co-founders are a good fit and can compromise.
  • Some issues like intellectual property rights (IPR) and who owns them can be critically important to business success. Ownership issues may be impossible to resolve once a business has reached a certain stage and acquired some value.
  • If your business idea doesn’t get off the ground and you decide to walk away, a founders’ agreement can be the only evidence you have to show what you agreed on in the beginning.

These are some issues to think about if you and your co-founders are considering a founders agreement:

  • Where are we going with this idea? What do we want for the future, and are we in this for the short, medium, or long-term?
  • What shall we do if our idea fails? What do we do if one of us isn’t pulling their weight?
  • What will our jobs be in terms of the start-up stage?  How much cash or other assets/time will each of us contribute? And if the start-up stage is successful and we move to put a formal, legal structure into place, how will this be reflected in equity ownership?
  • If we start a company and own shares, will we put a vesting schedule in place so that full rights to ownership are gradual over time and provided a co-founder sticks with the business?
  • What skills are we missing, and how will we choose someone to work with us?
  • Will we take salaries and if so, at what point?
  • How will we take decisions?  What will we do if we can’t agree?
  • What will we do if one of us becomes ill, or wants to leave? Can we make that person transfer IPR or other assets to us?
  • What shall we do about confidentiality, and what happens if one of us breaches confidentiality?
  • Can we work on other projects while we’re working on this start-up?
  • What if we need to take on an investor?  Are we prepared to give up a share of our ownership to that investor in return for their capital?

What should a comprehensive founders’ agreement consist of?

These are the terms that you should include in a comprehensive founders agreement:

The business

Describe your business idea and the market you’re operating in. Describe the sector, your product or service and your business goals. Determine if you’re open to exploring new areas of business, or if you want to concentrate on a single idea. Write down the time-frame you have in mind for the early stages, what success looks like, and what you envisage for the future.

Business culture

Detail the kind of company culture you want to create, for example are you laid-back and want the business to develop organically, or do you prefer a formal, structured approach? Decide on a name for your business early on and check whether this is available as a trade mark and domain name.

The co-founders

Identify the co-founders and decide whether someone else who participates directly or indirectly in the business like a spouse should have a more formal role. If you need to bring a third-party on board, decide how you’ll go about choosing them.

Length of the agreement, amendment and termination

Describe how long the founders agreement will be, how it can be changed and how it will terminate. Describe what to do if one of you becomes ill, disabled or wants to leave, or if one of you is under-performing.

Jobs and decision-making

Write down exactly what skills each of you are bringing to the business, and how you’d like the business to be presented to the outside world. Describe who will do each of the tasks that are necessary to the business but that neither (or both) of you want to do. Decide how to make decisions, and what to do if you can’t agree or are deadlocked.

Assets and ownership

If either of you are bringing any existing ideas, assets or cash to the business, describe how this will be translated into ownership. Describe more generally how ownership of the business will be divided up in the future, or how you anticipate making this calculation. Detail what to do if someone’s work rate declines after the company is formed, and whether the vesting of ownership should be staggered over time, for example by using a vesting schedule.

A vesting schedule means that ownership shares in a business accrue over time ­– this encourages continued participation and ensures that each person puts all their energies into the business.

If you have created any content, or any other business assets like software, describe who owns the IPR to this material. If only one of you has produced it, decide whether and when ownership will be transferred to the business entity you eventually create, and how this transfer will be reflected in that person’s share of the business. Make sure you detail who has ownership of the IPR in all of the products or services that are essential to your business, or a licence to use it, such as a website or software platform, a logo or an invention.

Secrecy and right to compete

A confidentiality clause is essential in a founders agreement, as is a non-compete clause. Describe what to do if one of you wants to leave and start a similar or competing idea, and what blocks you might want in place to prevent this. 

Next steps

Describe the decision-making process for moving to the next stage if your business is a success. You will probably want to set up a formal legal entity for your business, as this can give the owners with limited liability for the business entity’s losses protecting the assets of the shareholders. Putting in place a founders agreement enables you to anticipate the clauses that you’ll include in a shareholders’ agreement (if that business entity is a limited company), or a partnership agreement (if that entity is a limited liability partnership or LLP).

Here are a table that compares and contrasts founders agreements, shareholders’ agreements and partnership agreements.

 Founders agreementsShareholders’ agreementsPartnership agreements
Legally binding and in writing?NormallyYesUsually
Nature of the businessDescribed in detailDescribed generallyDescribed generally
Name and place of the businessPossiblyYesYes
PartiesThe co-foundersThe shareholders – usually the co-founders and possibly other people who’ve provided funding or other assetsThe partners – usually the co-founders and others who have or will contribute to the partnership in the future
Participation in the running of the businessYesNot necessarilyYes, including detail of how much time and what capacity each partner will make a contribution to the business
DurationNormally limitedTied to the life of the company or subject to termination eventsTied to the life of the partnership or subject to termination events
Accounting issuesNormally not neededDescribed generally in relation to dividendsDescribed in detail, including how profits will be calculated and shared out
Decision-makingInformal process usually includedUsually detailed provisions regarding decision-making processes and voting rightsUsually detailed provisions regarding decision-making processes and voting rights
LeadershipNot normally needed but you can nominate one of you to be spokesperson or informal CEONot usually relevant unless shareholders are also directorsYes. Normally nominated partners have particular roles and leadership responsibilities in terms of managing the partnership
MeetingsNot normally neededYes, in detailYes, in detail
Capital contributionDepends if a co-founder will be injecting cash in which case, yesUsually yes – as reflected in shareholding and classes of shareUsually yes – as reflected in partnership share
ProfitsNot expected at the early stage but you can provide what will happen if profits are madeYes ­– profits are normally distributed to shareholders as dividendsYes – profits are normally divided between the partners according to their respective contributions
New joinersHelpful to includeYes, including what rights existing shareholders have to object to new entrantsYes, detailed provisions
LeaversHelpful to includeYes, including what rights existing shareholders have to buy leaver’s sharesYes, detailed provisions
Expulsion for causeHelpful to includeNo, not usually as shareholders’ have passive roles in the running of the businessUsually, as partners contribute to the running of the business
TerminationYesYesYes
Dispute resolutionYesYesYes
Tax issuesNot normallySometimesYes

What about a founder exit agreement?

Start-ups are like marriages and other partnerships, and a solid co-founder relationship is crucial to their success. Everyone makes mistakes however, and if you fall out this can have a major impact on the success of the business.  Even happy relationships can have their ups-and-downs and disagreements, and your co-founder may decide start-up life isn’t for them, or they’d like to do something else.

As we’ve seen, putting a founders agreement in place that describes roles and responsibilities and how termination will be handled can help smooth the past of a co-founder exit. You certainly don’t want an ex co-founder continuing to hold a stake in the company if they’ve exited the business!

Even if you don’t want to put a full founder’s agreement in place, a founder exit agreement is the minimum protection we would recommend for any start-up. Handling departures professionally and quickly is the best insurance against a start-up business becoming derailed because of a co-founder exit.

Should you also consider drafting a founder IPR assignment agreement?

As you begin to develop your business idea, you are almost certainly going to create some intellectual property. IP can take many forms such as copyright in a business plan, piece of music or software, design rights in a model or prototype or trademark in a logo.

You and your co-founders may bring existing IPR to the business, or you may engage contractors and even friends to create it. You need to make sure that any such IPR belongs to your business or a co-founder and not a third party. Before a business is set up as a formal legal entity like a company or partnership, it can’t own property and therefore IPR can’t be assigned to it. However, your founders agreement can anticipate and describe what IPR assignments will be needed once this happens, and you can ask contractors to assign IPR to you as they create them pre-incorporation.

Should the agreement change pre/post incorporation?

As we’ve seen, founders agreements can be fairly simple and straightforward, and should contain an easy-to-use method for making changes so that you can adapt it as the business develops. That way, you can make changes pre-incorporation if you need to.

The terms of founders’ agreements are normally ‘rolled into’ shareholders’ agreements or partnership agreements once a formal legal body has been set up. If a co-founder doesn’t intend to have ownership shares but will, say, remain on the books as an employee, then certain aspects of the founders’ agreement may be reflected in their compensation package or service agreement.

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What next?

For more answers to commonly asked questions and advice on founders’ agreements, shareholders agreements, and other legal services for start-ups, consult our corporate solicitors. Get in touch on 0800 689 1700, email us at enquiries@hjsolicitors.co.uk, or fill out the short form below with your enquiry.

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