Why a Founders’ Agreement Is Important for Every Small Business

Updated on October 15, 2020
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If you’re an entrepreneur with that golden, once-in-a-lifetime idea, it can feel impossible to hit the brakes. The name of the game is momentum—slow down, and you’ll miss that window of opportunity, right?

But sometimes you have to press pause, take a deep breath, and make sure you’re not missing anything big before moving forward. It’s especially important to complete any legal items on your to-do list, so you can protect your business now and in the future.

If you’re planning to run your business with co-founders, then a founders’ agreement is essential. A business lawyer or online legal service can help you create one, or you can make a simple one on your own. This document outlines each owner’s rights and responsibilities, a very important step for avoiding conflicts among co-founders. We’ll show you what goes into one and exactly how to create one.

Importance of Having a Founders’ Agreement

A founders’ agreement is a baseline for how your co-founder relationships will work in the future, how your company is structured, and what each owner brings to the business. It’s important no matter what type of business entity structure you have.

In most cases, this document is optional—but we don’t recommend running a business without one. It is your insurance against the unexpected and the I-hope-this-never-happens. Don’t hurt yourself down the line by skipping an important step upfront! Drawing up a founders’ agreement is best done as soon as that sparkle in your eye becomes an actual business plan: when things progress from “I have this idea” to “Let’s actually do this,” you’ll want one to be drawn up. And if you’ve passed that stage already—better late than never. You can’t predict the future, but you can control the present.

Here are some of the reasons why having a founders’ agreement is essential:

  • Clarifies each owner’s role in the business
  • Provides a structure for resolving disputes among founders
  • Provides clarity if and when a partner wants to enter or exit the business
  • Protects minority owners
  • Signals to investors that you have a serious business

Lawyers and entrepreneurs understand that a founders’ agreement is an initial assessment of how things stand when the business is young. If circumstances shift slightly later on, it’s not that big of a deal. You can include procedures in this document for making necessary changes and updates. But it’s the ideal place for you and your co-founders to think through any potential problems you or your business might face—and to brainstorm solutions for the future.

Founders' Agreement

What to Include in Your Founders’ Agreement

Now that we’ve got what a founders’ agreement is generally, we’ll take a closer look at its bits and pieces. What actually goes into one? What will you need to discuss with your co-founder as you’re writing one up? What big decisions do you need to make before moving forward with your winning business idea?

Here’s what you should include in a founders’ agreement:

The Names of Co-Founders and the Business

The agreement names the founders and the company they’re agreeing on the rules for.

This might seem pretty basic—because, well, it is. But that doesn’t mean it’s not an important part of your founders’ agreement!

Naming your co-founders should hopefully be fairly straightforward and easy. There might definitely be some complicated cases here, but ideally everyone will be on the same page about who is actually investing their time, energy, and perhaps money into this company.

Naming your business might be a bit harder—but, chances are, this isn’t the first time you’ve discussed the issue. And if it is, then you’ve got a fun conversation ahead!

Length of Validity

Finally, you’ll want to clarify how long the founders’ agreement will remain valid for, as well as a way for all parties involved to willfully dissolve the agreement. Don’t forget to add in an escape hatch, in other words: you never know what’ll happen down the road. It isn’t going to legally bind you to continue working for your business forever, but even if you’re incredibly passionate and excited now, you should consider the possibility that your life might move in a different direction eventually. Prepare for every fork in the road, just to be sure.

Company Goals

This can definitely change as your business changes and grows, but it’s a good idea to get—in ink and on paper—what your company’s goals are. What products do you offer? Which industries are you operating in? What does your business look like to a consumer, a competitor, or an employee? What sorts of plans are you open to trying?

Maybe you’re a software-as-a-service business that plans on adding new major features every three months, or maybe you’re a mint chocolate cupcake bakery that will only ever sell mint-chocolate cupcakes. Either way, predicting and recording how you want your company to operate is an important step—though, again, not legally binding, so don’t worry if you end up pivoting your business model!

This could also be a good place to list your company values, work culture, and so on. What are your priorities? What’s the bigger picture?

Each Owner’s Roles and Responsibilities

Even if you run a tight ship of a small business, not every decision should be up to every co-founder… As much as it might feel like the opposite, especially if you’ve only just started your company.

The fact of the matter is that divvying up roles and delineating responsibilities early on lets you avoid confusion and redundancy. Two co-founders might both want to tackle every part of their business, but a CEO and a CTO? Not so much. Making sure everyone knows what they need to be doing means that you’ll have a less wasteful, more efficient business. The more specific you can get, the clearer it will be whether Bob is making unique contributions or reworking well-trodden ground. Cut costs and time sinks as much as possible, especially in your early days.

Of course, that doesn’t mean you need to abandon teamwork, transparency, and communication. In fact, by establishing distinct roles and responsibilities, you’re making it as easily understandable as possible who gets the final say on which things, and which other aspects of your business should be determined by consensus.

For example, maybe John is the expert marketer and Susan really knows how to make a pizza—should they both have to look at every advertisement that John runs in the local papers, or will that just stop them both from doing the work they need to be doing? You’re saving time, energy, and emotions by agreeing to these processes early on.

Finally, you’re creating a system of accountability—if something doesn’t get done, you know who the buck stops with. Likewise, if things do get done, you know who to congratulate. Accountability isn’t just a way to measure whether co-founders aren’t working hard enough: it goes both ways. You might even include rules for adjusting compensation, or equity, depending on performance.

Equity Breakdown

The co-founders of a business will naturally want to share the business itself—that’s the basic idea behind equity. But how do you divide your company’s equity among its co-founders? Deciding in your founders’ agreement will help you dodge misunderstandings, hurt feelings, and potentially worse.

First of all, you’ll only want to split up about 80%-90% of your equity—it’s better to save at least 10% for future hires and other circumstances.

Second, you’ll just need to have a long and serious discussion about the method and distribution of your shares. There are plenty of ways to do it, but there’s no one right way—it depends on your partnership, your business, and your personalities and contributions.

For example, some co-founders might just want to split the equity evenly between themselves. Others might want to distribute them according to the roles and responsibilities (which we discussed earlier!), or according to who fronted the most cash to get the business on its feet. Maybe you’ll give a bigger percentage to the person who came up with the idea in the first place, or to the one who coded the first demo or made the first batch.

Up to you. There’s no right or wrong answer. But it’s way better to have this conversation in the beginning. Just make sure that if two owners have equal equity and voting rights, you should include a tie breaking procedure of some kind so there isn’t an impasse on important company issues.

Vesting Schedule

You’re probably starting to see just how useful a specific founders’ agreement can be by now, huh? By laying out all of these financial details as early as possible, you’ll prevent any serious emergencies that a disagreement down the line might cause.

We can’t talk about equity without talking about vesting: if co-founders got their shares all at once, there would be nothing stopping half of them from hitting the snooze button and letting you do the work. By creating a vesting schedule—often four years with monthly installments—you’re encouraging everyone to earn their keep. Plus, investors will expect a market-typical vesting schedule, and not having one wouldn’t be a great sign.

Treat this section of your agreement seriously: it can have substantial consequences for your business. Check out some templates online, and set aside time to have these talks with your co-founders.

Intellectual Property

Intellectual Property is the creative material that goes into setting your business apart from every other business. That includes your products, recipes, marketing materials, logo, branding, packaging, website, business plan, theme songs, inventions, and more. Needless to say, your intellectual property is important to protect—and the founders’ agreement is a great place to do just that.

First of all, you should make sure that any intellectual property developed for your business goes to the entity itself, not to any particular person. For example, say one of your co-founders comes up with a great new recipe or procedure. Your agreement should state that any intellectual property devised for the business, during work hours, is owned by the business and not by any co-founder or employee who came up with it.

Ideally this would never become a problem, but suppose someone decided to break away and form a successful competing business—all because of an invention they came up with while working with you. Protect yourself—and your intellectual property!

To start, you’ll need to decide what constitutes intellectual property for your company. Anything the co-founders create, relating to the company, during work hours—that’s an easy one. But what about a co-founder on vacation brainstorming new ideas? If something was written in the “notes” section of a company phone, is it the business’s intellectual property? You might feel inclined to be hard-nosed about this, but that’s not necessarily the best approach.

Third of all, you should outline the terms for selling off your intellectual property—which may or may not include the terms for selling off the entire company too. Who has the authority to make that kind of decision? Where does that revenue go? These are just a few questions you’ll want to answer ahead of time.

Finally, considering discussing non-compete clauses and confidentiality agreements, too. Should a co-founder be able to own stock in competing companies? Or consult for competitors? Hopefully, this is never a problem for your business. But the whole point of a founders’ agreement is to be prepared, so even if you trust your co-founders more than your own grandmother, don’t give them an easy out in case things change without you realizing!

Salary and Compensation

Again, the salary and compensation part of the founders’ agreement is pretty basic—but incredibly important. Noticing the trend? We tend to overlook discussing these fundamentals when the entrepreneurial gears are spinning, but writing up an agreement forces us to address these topics… And clear up any mismatched expectations everyone could be bringing to the table.

It’s up to you how in-depth you want to go. You can create a thorough compensation plan that accounts for future growth, or you could just deal with present circumstances. Either way, setting a baseline will help you avoid unpleasant surprises.

Plus, this isn’t a bad place to consider figuring out how co-founders can use company money (or not!), whether they can own stock in the competition (and how much, if so?), and who approves investments or debt (and what the processes are).

Exit Clauses

Finally, a founders’ agreement should go over the circumstances of exit: what happens when a co-founder has been consistently underperforming, and needs to be let go? What if a co-founder voluntarily wants to leave the company?

Remember that while all of these conversations might feel awkward to bring up, they protect every co-founder equally. No one is exempt. The issues dealt with by a founders’ agreement are unfortunately not uncommon, and every good partner will understand the need for this kind of preparation.

That said, termination clauses can definitely be the most stressful topic to make a decision on. What would you want to happen if your co-founder flunked out on you? What would you want to happen if you were underperforming and dragging the business down? Or, alternatively, what happens if someone just wants to leave—for whatever reason they might have?

You’ll want to figure out what happens with unvested shares, especially. Often a company will have the opportunity to purchase those shares back from the founder at their original price, but that procedure is in your hands, too. Just setting up a system to deal with termination will go a long way—especially if that termination isn’t a friendly one and attorneys are brought into the picture. If that’s the case, your agreement will show that everyone previously agreed on a precedent in writing. That’s a powerful defense in the eyes of the law.

Founders' Agreement

How to Make a Founders’ Agreement

Excellent—now you’re a founders’ agreement pro. You know the ins-and-outs of what it’s for, who it’s for, and what goes into one.

But how do you actually make the agreement? There are plenty of options to make one. One of the best ways to get started is to use a template on a site like LegalZoom. It has a user-friendly questionnaire that walks you through the process of creating an agreement step-by-step. In the end, you have a founders’ agreement that’s customized for your company.

Here are more tips on making a founders’ agreement:

1. Find a template

There are plenty of founders’ agreement templates available online for you to peruse. Choose the one you and your co-founders like the most, or create your own with the best bits from each template you find.

Don’t stress out about the finalized language or legalese—ideally, you should take yours to a lawyer before you’re through. Just focus on getting all the important pieces together in one document!

2. Fill out the easy parts first

Names, company name, addresses, company address, phone numbers, date of inception, state and country… All that easy stuff shouldn’t take you too much time or energy to fill out.

Finishing off the quick work first sets you up for the next step and will get you invested in your founders’ agreement—you’re less likely to forget about it or prioritize other business matters more. Don’t procrastinate when making one! Like we said, the earlier you can get these issues settled, the better off your business will be.

3. Have the hard talks

Now that the easy-peasy is out of the way, you and your co-founders can sit down and have the serious discussions we brought up before. Compensation, equity, vesting schedules, roles and responsibilities, exit clauses—get it all nailed down here and now, so there’s never a procedural issue later on.

You and your co-founders might totally jive right away and agree on every point—or you might wind up compromising on even the smallest details. It’s hard to predict, and these aspects of running your own business tend to run very personal. It’s important not to shy away from any topics, so just be honest, tactful, thoughtful, and collaborative.

Once you’re through, record that admirable progress in your founders’ agreement. The toughest part is now behind you!

4. Make sure to work together

This isn’t a next step as much as a make sure you’re doing this right. Have you really had those serious discussions with your co-founders? If they weren’t aware of a founders’ agreement before, did you properly explain its importance? Were you collaborating or pressuring everyone into agreement?

Now is the time to double-check yourself and be clear that everyone is one the same page. The last thing you want is head to a lawyer and find that your co-founders have no idea what’s going on.

5. Consider visiting a lawyer

Owners are often able to put simple founders’ agreements together on their own. However, in more complicated situations, it can be wise to consult a startup lawyer. They’ll help you understand if it is lacking anything, what might be wrong with the template you used (or the changes you made), and what could bite you down the road. They’ll make sure that your founders’ agreement will pass muster in court.

Lawyers aren’t free, of course, but it’s well worth shelling out some of your business capital to insure yourself and your company against some easily preventable mistakes. Defer to the professionals in this case, because they’ll be the ones involved if something serious happens later on.

6. Ask fellow entrepreneurs

Once your lawyer looked over the founders’ agreement, you might want to send it around to a few trusted entrepreneurial friends. If you or your co-founders feel uncomfortable with sharing compensation and equity, you can always black-out those sections. Often, another small business owner’s personal experience can help you predict some cases that a lawyer might not have seen. Make any changes you need to make based on everyone’s advice, and sit on your decisions for a bit to see how they settle.

Also, make sure to let your fellow co-founders know that you’d like to send out your founders’ agreement for peer review before doing so. This can be sensitive material for some.

7. Finalize, and sign

Your founders’ agreement won’t be legally binding until all the owners have signed and dated it. Make sure you give each owner enough time to review the document. Each owner might choose to retain their own lawyer to protect their own interests.

This is the moment you’ve been waiting for! Once you and your co-founders sign the document, you should store electronic copies in the appropriate place for safe keeping.

Founders' Agreement

Founders’ Agreement: The Bottom Line

Congratulations! You’re one step closer to running your small business, following best practices along the way. A founders’ agreement might not seem like the most crucial or exciting part of being an entrepreneur, but it’s incredibly important—and fruitful. You’ll learn a lot about your business, your co-founders, and yourself along the way.

If you get stuck while drafting one, consider getting help from the professionals at LegalZoom.

Priyanka Prakash, JD
Senior Contributing Writer at Fundera

Priyanka Prakash, JD

Priyanka Prakash is a senior contributing writer at Fundera.

Priyanka specializes in small business finance, credit, law, and insurance, helping businesses owners navigate complicated concepts and decisions. Since earning her law degree from the University of Washington, Priyanka has spent half a decade writing on small business financial and legal concerns. Prior to joining Fundera, Priyanka was managing editor at a small business resource site and in-house counsel at a Y Combinator tech startup.

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