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Startup Founder Agreements February 22, 2010

I have been thinking a lot recently about how to apply agile development principles to investing and key aspects of startup development such as team building. That’s also the thread connecting my two recent posts on VentureHacks. Both stem from the agile principle of delaying decisions until the last responsible moment. The first post is about agile startup fundraising. The follow-on post is about agile startup team building. If you’ve read and liked these posts, let others know.

The same question came up a few times in different forms in the comments to the second post:

@Nivi

Simeon, can you tell us how you structure ownership and control so you can fire your co-founders if necessary?

This is a complex topic that has a business and legal side to it. I’m no lawyer, so I’ll look at things from a business perspective. I will mention legal terms and example language for illustration purposes only—for details, consult a lawyer. This isn’t just CYA. There are a lot of possibilities and variations that need to be thought through and for that you need legal and tax advice.

This post addresses the lifecycle of founder agreements and the key compensation and control parameters in them. A companion post suggests ten rules for building better founding teams.

Urban legends

Let’s start by dispelling some myths:

• There is a standard founder agreement. Well, there is and there isn’t. Every major law firm and every VC firm tends to have some type of template. These templates can have meaningful variations, some of which are founder-friendly and some of which are not. Most partners, be they lawyers or VCs, tend to tweak the standard with their own language. Even if you are an experienced entrepreneur, you’ve probably only seen a few founder agreements in your life. Almost anyone can benefit from a great lawyer or an adviser who’s seen dozens of these from different law & VC firms.
• All founders have the same agreement. Yes, it is convenient for all founder agreements to be based on the same template with the only difference being the number of shares. Don’t confuse a convenience with a requirement. In the last four companies I’ve co-founded, there were several founder agreement types. In two cases this was because of the special role I played as a part-time co-founder. In one case the CEO had a different vesting schedule because he had spent a lot more time than the rest of the founding team on the idea. In another case, for good reasons, four founders had three meaningfully different agreement types.
• Founder status == founder agreement. Founding status can be bestowed on anyone. That’s a decision a founding team can make for many reasons. As long as the decision is public and definitive, from an external perspective there is no issue. This can be a convenient shortcut to separate someone’s status (founder) from their role (employee or contractor or advisor, etc.) and the legal documents specifying its rights & responsibilities.

Which founder agreement?

There are several critical points in a startup’s life when founder agreements are put together.

There tend to be verbal agreements between founders for a period of time before anything is put to paper. Lawyers tell me that in many cases verbal agreements are enforceable, especially if someone did work based on the verbal agreement. It helps to communicate and set expectations clearly. It also helps to have some discoverable record of the agreement. An email would do.

At some point pre-incorporation, the founding team may create a written agreement, often in the form of a letter. It outlines key points of agreement between founders around IP ownership, equity ownership, vesting, etc. The FastIgnite one is two pages. The goal of the letter is to be simple and readable so that everyone is comfortable and aligned on the main issues. Perhaps the most important paragraph is the pre-formation agreement. It requires the various parties to behave during incorporation in a way that effects the agreement. It can be something along the lines of:

Pre-Formation Agreement.  If the addressee of this letter consists of one or more individuals, rather than a business entity, the individual(s), by his (their) signature(s) below agree(s) that they will cause any business entity formed by them within 24 months of the date of this letter agreement to conduct business in the Field of Interest to enter into an agreement with me identical to this letter agreement, whereupon this agreement shall become void.  If such individuals do not form a business entity to conduct business in the Field of Interest, but instead sell or assign their developments and technology in the Field of Interest to an unrelated party, I shall be entitled to [this will vary based on the type of founder] of the net consideration received by reason of such sale or assignment.

Pre-incorporation, removing a founder is complicated primarily by the potential lack of clarity around his or her rights and obligations and hence the consequences the removal. For example, without a clear vehicle (a company) to contribute intellectual property into, a founder who walks away may mean that the future company won’t own its own IP. This is typically not a problem, unless the company becomes very valuable and the founder who walked away decides that she is owed something.

During incorporation, the couple of pages of this letter will be turned into somewhere between 20 and 50 pages of mostly boilerplate legalese. The number of separate documents may vary but they fall into two categories:

• Those related to equity, typically a restricted stock purchase agreement (RSPA) and associated escrow and other agreements.
• Those related to other matters: IP assignment, invention disclosure, non-solicitation, non-competition, termination, etc.

At this point, there is a precise, well-defined legal framework for resolving conflicts that can’t be addressed through other means. However, founder agreements are not set in stone and it is common for them to be tweaked by a little or a lot during the first financing by professional investors. How to handle that or avoid it altogether is something I’ll do a post on if there is interest. [more details]

Founder roles, agreements and removal strategies

Different founders contribute different assets and capabilities and can play multiple roles. Their agreements tend to reflect this and, hence, the strategies for a founding team to remove these founders differ. Note that investors have additional tools at their disposal but that’s a separate topic.

• Employee. Compensation is a combination of cash (post funding) and common equity that is subject to vesting if professional investors are involved. There is some up-front vesting acceleration. The common number is 25% but, depending on the length of time and contributed resources, it can be up to 50%. (See my post on the best vesting schedule.) The rest of the equity typically vests monthly with no cliff for 3-5 years. Founders have rights as shareholders. They have voting rights which may entitle them to force or veto certain key decisions, e.g., hiring or firing the CEO, selling the company, raising money, etc. You need to understand the voting thresholds for key decisions and think very hard about whether you want to allow any one founder to have too much control. If you are the lead founder, this may not be an issue but it should be an issue for the founding team as a whole. Another issue to watch out for is any significant vesting acceleration on termination without cause outside of a change of control (an exit). A little bit is OK. A lot is unreasonable. Yet another issue is the price at which the company can repurchase unvested shares. To make this cheap for the company, you want the price to be the par value of the shares.
• Investor. Founders who also invest get additional equity in the company with no vesting. Some get common equity for their investment. Smarter founders structure things such that they get preferred equity together with other investors. The smartest founders who put money in their own businesses put it through a separate preferred class of stock before other investors come in. As preferred shareholders they will have additional rights. With the right legalese, even a small shareholding can exert a huge influence and make it near impossible to remove the founder. The only way to remove their equity holding in the cap table is by buying them out or through a recapitalization of the company. In this case you have to consider whether they are common or preferred holders and, in the latter case, their anti-dilution protection, pay-to-play provisions and willingness to participate in the recap financing. A much better approach is to restructure their holding during an investment, at the point of maximum leverage.
• Advisor. The structure depends on the nature of the advisory work. Very early on, if the equity ownership is small, the advisor equity may have no vesting. An example would be when someone gives you an idea and you run with it without their involvement. Typically, advisors tend to have shorter vesting periods (one or two years). If you like them and they have been helpful, you sign them up for another term. Sometimes, the vesting is milestone-based (upon the close of a financing) or performance-based (signing up customers, doing deals, recruiting). Advisors tend to have 100% acceleration on change of control. Typical advisory agreements have simple termination clauses. As long as that’s the case, there should be no major issues in removing an advisor founder.
• Service provider. Like the advisor role, a service provider can do many different things. The difference is that there is some type of cash component or cash equivalent value associated with the services. There are multiple ways to handle this before the company has cash. It can be deferred, with or without interest, to be paid after a financing or once revenues start coming in. Alternatively, it can accrue into equity at some pre-defined price-per-share, usually the next round’s, perhaps with a slight discount. For example, you hire a consultant for five months at $10K/mo and then you raise $500K on $1.5M pre. For her services, the consultant will own common stock equal to $50K/$2M or 2.5% of the fully-diluted capitalization of the company. If equity compensation and vesting are aligned with how value is delivered, terminating a service provider founder should be no problem.
• Board member. Board members differ from other parties in that they are purposefully difficult to remove. Therefore, they tend to worry less about vesting schedules. Founder directors often get the same initial acceleration as employee founders. They get 100% acceleration on change of control. Independent of shareholder rights considerations, whether it is easy or difficult to remove a founder board member depends on the rules of board composition. Be wary of board seats by entitlement. Rather than giving board seats to individuals, give them to (groups of) classes of equity and check whether the voting process doesn’t automatically give any one founder the right to be the board member. If a board member founder is not entitled to a seat, then there are various other processes described in the bylaws which may affect his removal.
• Executive board member. Typically, the agreement is a mash-up of a board member and a service provider agreement. The usual role that fits this is a founding executive chairperson. Initial vesting typically matches employee founders. Further vesting accelerators are common, e.g., on follow-on financings or the recruitment of a CEO. The removal strategies are the same as for a board member.

The same person can be in multiple roles and may even have multiple agreements. While there are no “best founder agreement structures,” just as there are no best vesting schedules, there are certain principles of approaching founder agreements that can be helpful in building stronger and more agile founding teams. Read the next post in the series for ideas on how to build stronger startup teams.

Let me know what you think in the comments or on Twitter @simeons.