Cofounding a company together is sometimes compared to entering a marriage. As with any marriage, everyone goes in with high hopes and the best of intentions, but inevitably there will be unforeseen problems and sometimes things just don’t work out. And just as it can be beneficial for some couples to enter into a prenup, so it can be incredibly valuable for founders to put in place an agreement that spells out what their rights and obligations are towards each other and the company in certain circumstances.
During Startup Boston Week 2020, I provided a quick lesson on this important contract during the session Founder Essentials Bootcamp: Navigating Cofounder Agreements. Check out the recap of a few key points below:
What is a Cofounder Agreement?
Fundamentally, a cofounder agreement is a contract among founders of a company that is typically entered upon incorporation and that addresses key issues pertaining to the relationship among the founders and between the founders and the company such as:
● Determining control of the company
● Aligning incentives
● Resolving disputes
Who Has Control of the Company?
In a corporation, control of the company is shared by the stockholders and the Board of Directors. The stockholders elect the Directors and must approve certain major corporate actions, such as a sale of the company, while the Board of Directors appoints and oversees management and typically must approve any action that could have a material effect on the company’s business (i.e. issuing securities, raising capital, hiring/firing executives, acquiring another company or a sale of the business).
During the early days of a corporation, founders control most (if not all) of the company’s, voting power and the Company’s Board is typically comprised of the founders, but that doesn’t mean each founder has the same say in decisions because while stockholder votes are weighted by ownership interest (i.e. a stockholder owning 30% of the company has more voting power than a stockholder owning 20% of the company) each Director gets one vote. When entering into a cofounder agreement, the founders should think carefully about which founders will have a seat on the Board and what actions should require stockholder approval.
Typically, a cofounder agreement will provide that each founder will initially have a seat on the Board – and that each founder will vote for the election of the other founders to the Board – but that a founder will lose the right to a Board seat if he or she leaves the company or if his or her ownership falls below a set percentage. This allows the founders to keep control of the Board in the hands of the founders who are active in the business and have the greatest stake.
Additionally, a cofounder agreement usually prohibits the company from taking certain actions without approval of the founders. Since stockholder votes, unlike Board votes, are weighted by ownership interest, careful consideration should be given to the threshold for founder approval. For example, if one founder owns 51% of the company, the other founders may push to require that certain actions, such as a sale of the company, require approval of more than 51% of the founders voting power to ensure the majority founder cannot act unilaterally.
Provisions to Align Founder Incentives with Company Goals
A common goal of a cofounder agreement is to ensure that the fortunes of the founders are tied together. This is achieved is by limiting the ability of a founder to transfer his shares in the company apart from the other founders, and by limiting the ability of a founder to block a sale of the company approved by the other founders.
Founder agreements will typically prohibit any voluntary transfer of a founder’s shares, except for estate planning, unless the transfer is approved by some or all of the other founds. It will typically also provide that if any shares held by a founder become subject to an involuntary transfer – such as to heirs if the founder dies, to a creditor in a bankruptcy, or to a former spouse in a divorce – the company and/or the other founders will have the right to purchase those shares. These restrictions help keep the active decision-makers in control of the company. If the agreement permits the purchase of a founder’s shares in certain circumstances, it is important to clearly define the methodology for determining the purchase price for the shares the timing of payment.
Usually, these agreements will also include a provision, usually called a “drag-along” provision, that requires that all founders go along with a sale of the business if it is approved by the founders holding a threshold ownership percentage. This prevents some or all founders (depending on the threshold) from stopping a sale of the company.
In a worst-case scenario where founders simply cannot agree on how to resolve a dispute, having a dispute resolution methodology in place can prevent the dispute from destroying the business. A cofounder agreement may provide for one or more methods of dispute resolution.
Most commonly, the agreement will require that the founders submit any dispute to mediation or arbitration. Some agreements will also include a buy-sell provision allowing a founder to initiate a process by which he or she would either sell his or her shares to the company or the other founds, or would buy out the shares of one or more other founders.
NOTE: In this article, we’ve laid out some of the key issues you and your cofounders should consider before entering into a cofounder agreement, but as with any agreement the appropriate terms are highly dependent on the parties and the situation so we strongly recommend you consult with an attorney with ample experience working with startups.
And to watch my full talk from Startup Boston Week 2020, click here.