What is the most important business agreement for your company?
In a 6-week series, Izwan Zakaria, the Managing Partner of Izwan & Partners will be covering legal topics and trends affecting technology entrepreneurs and startups.
If you missed his earlier guests posts, check out Part 1, Part 2 and 18 New Year’s resolutions for founders and entrepreneurs. In his latest write-up, he offers founders and entrepreneurs tips and quips on getting the right agreements down for their businesses.
As an entrepreneur or a founder, if there is only one agreement you can ask from a corporate lawyer for your company, what will that agreement be?
There are many business agreements out there. Let’s play a guessing game. Are you going to choose an employment agreement? Non-disclosure agreement? Non-compete agreement? A purchase order? Licence agreement? Website terms and conditions? Privacy policy? A purchase agreement? Or any other type of agreement?
As a corporate lawyer for over a decade who have worked on a wide range of legal work for bootstrapped startups and venture-backed companies, I believe there is one single most crucial agreement that every business owner, entrepreneur, and a founder should have; an agreement covering the following items below.
These agreements are usually known as a shareholder’s agreement, stockholder’s agreement, founder’s agreement, and also known as a partnership agreement in some places. Although they may go as different names, entrepreneurs and founders should ensure that they cover the following issues in such an agreement.
By default, if you don’t have a shareholders agreement in place between the shareholders (during the initial early stage of a company, usually only between co-founders), the “fallback” positions for the commercial terms will be based on the existing companies laws. In other words, the default positions under the statutes covering such issues may or may not be in your favour.
If you don’t have this agreement in place addressing these commercial issues below, you may likely get into a dispute that may end in a courtroom (that means an expensive long legal battle!).
In my experience, I have seen entrepreneurs lose their business due to failure of setting any agreement in place. I also know founders like to ignore the importance of discussing these important issues for the sake of trying to avoid a ‘difficult conversation’ with their team members.
If you don’t want to address these issues upfront before you start the business, you may end up getting into a major disagreement once you start running the company especially in stressful times like fundraising or even scaling a business.
If you don’t want to have this difficult conversation for fear of upsetting the other founder, you may be doing yourself a favour and be better off by not starting a venture with the person. The company may not be able to survive a deadlock when there is no way out in a shareholders’ dispute, especially when there is no agreement in place to resolve such conflict.
When drafting a shareholder’s agreement, make sure you work with a corporate lawyer to address and answer all these important questions.
1. Different founders bring in different expertise and skillset to a business. What are the specific contributions that will be made by the respective founders to the business? What if one founder puts in cash? But the other founder only provides his sales skills? How will each of these contributions get treated and be valued in monetary terms?
2. In practice, when there are only two founders, both founders tend to agree for their equity ownership to be owned equally (personally, I do not recommend this). How will you both decide if there is a deadlock between both founders? In other words, both of you can’t agree on a matter and end up with a tie vote? Will the voting deadlock get fixed by a third party independent and trusted person (like a neutral friend) to come up with a final deciding vote? Or even trigger a buy/ sell agreement (usually known as a ‘shotgun agreement’) for a founder to acquire the shares by the other cofounder when both cannot agree on a decision), or mediation, arbitration, or another method?
3. What if an existing founder decides to leave the business after six months after starting a company with you because he decided to accept a different role or leave the country to start a new venture some place else? What will happen to the shares that have been issued upfront to the outgoing founder (usually known as a vesting schedule)? Will it get forfeited or can it be retained by the outgoing founder? And how will the business handle the departing founder’s exit and his equity interest? And how will the business onboard a new founder?
4. What if a founder develops a new software? Will the founder be required to assign the ownership of the software to the company? How will the founders decide what type of intellectual property assets needs to be assigned to the company? Can a founder merely licence out the platform to the company for a fee?
5. What if one of the co-founders only has 30% equity ownership in the company? What are the safeguards in place to ensure that he is protected against critical business decisions as a minority shareholder?
Some of the usual critical business decisions include:
● Deciding on the salaries of the staff
● Hiring new staff or firing existing staff
● Selling assets
● Changing the business direction
● Agreeing on a budget
● Onboarding new founders
● Taking up loans or issuing loans
● Getting the founders to put in additional capital contributions (also known as a ‘capital call’)
● Entering a contract or terminating an existing contract
● Investing in other new ventures
● Winding up i.e., closing a business
6. How will you decide who gets to be a member of the board of directors? How will the board member be elected? Will certain founders have a right to be on the board or to appoint several directors? How will a director get removed from a board seat? Only for certain grounds or for any reason? How will vacancies on the board get filled? If the board of directors decides to set up new committees like an advisory committee, how will the members of these committees get selected, removed, and replaced?
7. Are the founders of the business bound by confidentiality obligations? What amounts to “confidential information” in a business? What type of safeguards are in place to protect the business from the co-founders disclosing proprietary information?
8. Are the founders of the business required to dedicate their time exclusively on the business? Or have the founders agreed not to undertake any other similar venture that may be in competition with the business?
9. What if the company’s cash runway is depleting in several months? What will be the first preferred mode of funding? Will it be equity funding or debt funding? What if one of the founders fails to contribute to the capital call?
10. Let’s say the business makes profits which allows the company to issue out dividends (i.e. the distribution of the company’s earnings to its shareholders). How will the founders decide how much the company’s dividends will be? Will it be agreed upfront or based on a certain threshold? And how often?
11. If a founder fails to fulfil his obligations to the company be it failure to achieve certain business milestones or deliverables, will the founder be compelled to sell his shares? If so, how is the value of the equity interest will be assessed and determined by the founders? Will the founders agree on an upfront formula? Or engage a third-party valuer (like one of the Big Fours accounting firms)? Or a combination of the two? Also, which party will be responsible to pay for the fees and charges in relation to the equity transfer? Will the final purchase price for the equity be paid in a lump sum? Or can it be paid over a certain timeline?
12. What are the restrictions and conditions in place if a founder wants to transfer his shares in the company? Can the founder transfer the shares to anyone whether its a competitor, an enemy, an ex-girlfriend, or anyone that may not be beneficial to the company? Will existing founders or shareholders have the right to match any offer received by another potential buyer seeking to sell his equity interest?
13. What if there is a dispute among the cofounders? How will the shareholders resolve their dispute between themselves? Will it be resolved by a judge in a normal court? Mediation? Arbitration?
Dealing with these commercial terms can be overwhelming for many new aspiring entrepreneurs or founders. But look at having a shareholder’s agreement as a statement or a record of your understanding between your cofounders. So, if there is any dispute, any founder can refer to their shareholders’ agreement to find out what was the initial agreement in terms of the relevant roles and responsibilities agreed by the cofounders and even the investors in a company.
Izwan Zakaria is the managing partner of Izwan & Partners, a corporate and technology law firm. He is also the author of The Startup Law Blog, a website covering legal topics and trends affecting technology entrepreneurs and startups in Malaysia. He can be contacted on Twitter at @izwanzakaria1 or email at izwan@izwanpartners.com.