A Founders' Agreement Can Only Be Made While the Founders Get Along

Hello, I'm Noriaki Asato, Representative Attorney at LegalAgent.

When people think of startup legal work, they tend to focus on the contracts that are most visible in dealings with outside parties, such as financing agreements, stock options and service agreements. Of course, all of these are essential issues for running the business. Particularly in the run-up to a Series A, the number of items that investors check increases sharply, including the investment agreement, the shareholders' agreement and the ownership of intellectual property.

However, when I work with companies in their earliest days, there is one contract that I feel should be addressed at a very early stage. That is the founders' agreement.

A founders' agreement tends to be seen as "a contract for when co-founders fall out." In practice, though, while it is not legally impossible to sign a contract after a dispute has arisen, once an emotional conflict has developed it becomes extremely difficult to reach a realistic agreement. I think of it, rather, as a contract whose terms can be settled realistically and in a way everyone accepts precisely during the period when the founders are facing the same direction and trust each other.

The main subjects of a founders' agreement are the ownership of shares, the treatment of shares when a founder leaves, non-competition, and the rules for making day-to-day and important decisions. When a company has just been launched, people are inclined to think, "We are friends who understand each other, so we don't need to decide things in that much detail." In actual financings, however, investors do not look only at the figures showing "who holds what percentage of the shares." They also carefully assess whether those shares are in the hands of founders who will keep working responsibly toward the growth of the business, whether the departure of someone midway would put an unreasonable strain on control of the company or on its incentive structure, and whether a change in the personal relationship between the founders could bring the company's decision-making to a halt.

The Role of a Founders' Agreement and Why It Should Be Prepared Early

Why the Discussion Should Take Place While There Is Trust

The difficulty of putting a founders' agreement together lies less in the technical side of what wording to use in the contract than in the timing of the discussion itself. When the co-founders are on good terms, topics such as "What happens if one of us quits midway?" or "Will we buy back the shares that person holds?" are inevitably hard to raise. It is only natural to worry that you may come across as distrusting the other person, or that you may put a damper on a good relationship.

Once the relationship between the founders has deteriorated, however, or a gap has opened up in their commitment to the business, the same topic becomes far harder to address. The departing founder and the remaining founders tend to have very different views of the shares. When a co-founder who already holds a considerable proportion of the shares leaves the company, the remaining side will likely feel that "it is unnatural for a former member who will no longer be involved in the business to keep holding a large stake." The departing side, on the other hand, will naturally feel that "keeping the shares is my rightful due as compensation for launching the company during the high-risk founding period."

If the parties only begin negotiating "how much to pay for the shares" at that stage, the discussion easily develops into an emotional clash. The more the company's prospects have begun to come into view, the greater both the economic value and the psychological weight of the shares.

The role of a founders' agreement is to decide how matters will be adjusted with the remaining founders while also taking account of the interests of the person leaving. It is an agreement, made while there is still mutual respect and trust, to ensure that the company can keep moving forward without stalling even if one person's life path or values change in the future. Whether someone can no longer continue for health or family reasons, a serious breach of obligations has occurred, or a founder leaves amicably because of a difference in management policy, it is important to put into writing, while the matter can still be discussed calmly, how the interests of the company and the individual will be balanced in each situation.

The Incentive Structure That Investors Examine

In a full-scale financing such as a Series A, investors check how the founders hold their shares and whether they can maintain their motivation to work on the business after the investment. For companies at the seed to Series A stage, future growth prospects carry great weight in valuing the company. Even if the product or revenue is beginning to take off, whether the business can grow substantially depends on whether the management team, centered on the founders, can continue to give it their all.

For this reason, if a founder who has already left remains with a large number of shares, or if there is no settled method for handling the shares if a key founder leaves, this is likely to become a major concern for investors.

If the treatment on departure has been worked out and put in writing in advance, the company can clearly explain to investors as well that it has fully grasped the potential risks relating to the founders' shares and has addressed them in a reasonable way.

The Legal Nature of Shares and Their Treatment on Departure

Shares as Control and the Need to Share Assumptions in Advance

In the early days, one sees cases where shares are allocated as if they were "compensation for the work of the founding members." In a startup with limited cash on hand that cannot pay sufficient directors' compensation, having the founders who shouldered the early risk hold shares is in itself a natural decision. Precisely because they hold shares, they can devote their efforts to increasing the company's long-term value without being preoccupied with immediate salary.

However, shares are more than monetary compensation. They are a means of control that influences the company's decisions through voting rights at the shareholders' meeting, and they are rights directly connected with important events such as future financings, M&A and reorganizations.

Moreover, under the Companies Act, shares are the founder's personal property. Leaving the company does not automatically mean that they are returned to the company or lost. The company or the other founders cannot legally take them away unilaterally, and the arrangement needs to be designed either by entering into an agreement in advance or by following procedures in accordance with the Companies Act.

If a large proportion of the shares is handed over while this premise remains vague, it is difficult to adjust matters later. Suppose, for example, that a co-founder in charge of technology was given 30 percent of the shares but leaves just six months later because of a difference in direction. If nothing had been agreed in advance, that person may remain a major shareholder holding 30 percent even after leaving. From the perspective of those who remain, this places significant constraints on future management decisions, new financings and the design of the pool for granting stock options to employees. From the perspective of the person who left, on the other hand, there is also some logic in wanting to keep the shares as fixed consideration for their contribution at the founding.

What matters here is the shared understanding, reached in advance, of the premise on which the shares were given. Are the shares regarded as fixed consideration for past contributions, as a means of encouraging continued commitment into the future, or as a mechanism under which rights vest in stages by continuing to work for a certain period? Sharing this understanding in writing in advance lays the foundation for preventing major discrepancies at the time of departure.

The Practical Limits of Transfer Restrictions in the Articles of Incorporation

Many startups place restrictions on the transfer of shares in their articles of incorporation. The Companies Act allows the articles of incorporation to provide that the acquisition of shares by transfer requires the company's approval, and this helps, to a certain extent, to prevent an undesirable third party from suddenly coming in as a shareholder. The body that grants approval for transfers is also determined according to whether the company has a board of directors and what the articles of incorporation provide.

However, a transfer restriction in the articles of incorporation is merely a mechanism mainly for preventing undesirable third parties from becoming shareholders. It does not automatically resolve the question of how to deal with the shares held by a founder when that founder leaves. If the departing founder does not try to transfer the shares to a third party and simply keeps them in their own name, the transfer restriction in the articles of incorporation imposes no constraint at all.

Furthermore, where a founder dies and inheritance occurs, or where there is a division of property upon divorce, a personal bankruptcy or the like, there is a risk that a shareholder composition the company did not intend will arise even if the person concerned has no ill intent. Article 174 of the Companies Act provides a system under which the articles of incorporation may stipulate that the company can demand that a person who acquired restricted shares through inheritance or other general succession sell those shares to the company. However, the demand for sale under Article 174 of the Companies Act is directed at general succession such as inheritance, and does not automatically extend to division of property upon divorce or disposition in bankruptcy proceedings. The transfer approval procedure appropriate to the cause of acquisition, and the effect of contractual purchase and sale obligations, are therefore checked individually. It is desirable not to stop at the transfer restriction provisions in the articles of incorporation, but to establish a relationship in which these are combined with, and complemented by, a founders' agreement.

Companies Act Procedures and the Design of Compulsory Sale Clauses

At the core of a founders' agreement is a clause that imposes an obligation on the founders who are parties to the contract to sell their shares when certain events occur. In practice, these are called compulsory sale clauses, buyback clauses and the like. Such a clause is merely a contractual agreement binding the parties who signed it, and differs in nature from a compulsory acquisition procedure, such as class shares subject to wholly call under the Companies Act, which automatically binds even shareholders who have not signed any contract.

There are reasonable grounds for preventing a situation where a founder continues to hold a large number of shares despite leaving early, and for enabling the company or the remaining founders to recover shares in the event of a serious breach of obligations, competing activities, removal of confidential information or the like.

However, a compulsory sale clause is a powerful provision that directly restricts a founder's personal property rights. If the conditions for triggering it or the method for calculating the purchase price are vague, it may therefore become a cause of future disputes. In practice, the parties work out points such as what events give rise to the obligation to sell, who can demand the purchase, whether the purchase covers all or part of the shares, how the price is calculated and when the price is paid.

What should be noted here is that simply providing that "upon departure, the company will buy all the shares" is not sufficient. When the company buys shares as treasury shares, it must satisfy the prescribed procedures under the Companies Act, such as a resolution of the shareholders' meeting, and it is also subject to financial resource regulations under which it can acquire shares only within the scope of its distributable amount. A design that anticipates situations where the company itself cannot buy the shares because of its cash flow or the financial resource regulations, and that also provides a mechanism allowing the other remaining founders or a third party designated by the company to buy them, is worth considering.

Careful attention is also essential in setting the purchase price. If, with a punitive intent, the agreement provides for purchase at an extremely low price or a nominal amount, there is a risk that it will be treated as a low-price transfer for tax purposes, giving rise to unexpected tax exposure, and that the validity of the clause itself will be disputed from the perspectives of accounting treatment and fairness between the parties. No calculation formula guarantees that a particular amount will always be safe from a tax or legal standpoint, so it is desirable to adopt a price standard that can be reasonably explained.

Whether to treat all reasons for departure uniformly is also an important consideration. Should a departure due to a serious breach of trust or competition be treated on the same terms as an amicable departure due to illness, family circumstances or a friendly difference over management policy? Or should the proportion that can be bought back decrease in stages according to the length of service? Structuring the clause around objective criteria that do not give rise to subjective conflict is useful in practice.

Non-Competition, Confidentiality and Representations and Warranties in Practice

Non-Competition and Confidentiality Tailored to the Founder's Position

Founders are in a position to know the company's important information, such as its business plan and technical specifications. They may also be familiar with customer relationships, pricing strategy and cash flow. Consequently, if a founder leaves the company and then launches a competing business or becomes involved in a business targeting the same customer base, this can be a heavy blow for the company left behind.

That said, a non-compete obligation directly restricts a founder's personal freedom to choose an occupation and freedom of business activity. Being a founder does not mean that activities can be prohibited without limit, and in court practice the reasonableness of the restriction is judged case by case. Simply providing that "for two years after departure, the founder shall not engage in any business identical or similar to that of the company" carries the risk that the scope will be too broad and its effect denied. In startups especially, where business areas tend to change, it is not unusual for the business at the founding and the business several years later to differ greatly.

For this reason, when including a non-compete clause, it is realistic to identify specifically the business area that the company genuinely needs to protect, keep the period and geographic area of the prohibition within a reasonable scope, and also sort out how to treat matters such as small passive investments and activities approved in advance.

The same applies to confidentiality obligations. Even among close colleagues, it is necessary to make clear what constitutes the company's confidential information, for what purposes its use is permitted, and how it will be returned or destroyed on departure. Precisely because founders have access to the company's core information, it fits practice to go further than general work rules for employees and set terms in line with the founders' actual authority and work. In legal due diligence at the time of a financing, too, investors carefully check whether key trade secrets and intellectual property are protected within the company.

Ownership of Intellectual Property and Representations and Warranties

The term "representations and warranties" may be strongly associated with investment agreements and M&A, but it also serves a useful function in a founders' agreement. Typical items that should be confirmed among founders are as follows.

• That there is no doubt about the rights, vis-a-vis third parties, in the intellectual property or funds that the founder provides to the company
• That the founder has not brought in information or deliverables in breach of contracts with a former employer or past clients
• That there is no existing work or side business that competes with the company's business, or that any such work or business has been disclosed

In the early days, because development speed is given priority, the environment tends to become a mixture of code managed in personal accounts, data created during a previous job, verbal promises with acquaintances outside the company, and the like. If program code written at a previous job has been incorporated into the product as is, or the rights to core technology have been retained by an individual, this can later develop into serious legal trouble and greatly impair the company's value.

Representations and warranties are not merely a procedure for doubting the other party. They function as a joint check in which everyone reviews the rights in the assets they bring to the company and puts things in a state that can withstand future due diligence.

Decision-Making Rules and Consistency with Investment Agreements

Allocating Roles Between Voting Rights and Corporate Body Decisions in Preparation for Disagreements

In a founders' agreement, alongside the handling of shares, another major issue is how to set the rules for day-to-day decision-making. Where two co-founders each hold 50 percent of the shares, this functions as an equal partnership while the relationship is going well. However, if they disagree over policy, resolutions of the shareholders' meeting may fail to pass and important management decisions may come to a standstill.

Even where three or more people founded the company, management agility is greatly affected by whether decisions are made by majority vote, require unanimity, or leave a certain scope of discretion to the representative. A rule requiring unanimity for everything gives the minority a de facto veto and can hinder the speed of business growth. On the other hand, a design under which the representative can decide everything alone can cause the other founders to lose trust.

In a founders' agreement, it is therefore effective to draw an appropriate line between day-to-day business execution and important matters requiring agreement among the founders. One possible design leaves ordinary hiring and day-to-day sales policy to the discretion of the representative or the director in charge, while requiring prior agreement among the founders for borrowings above a certain amount, changes to the main business plan and the like.

What should be kept in mind is not to confuse contractual agreements among the founders with the decisions of corporate bodies, such as the shareholders' meeting and the board of directors, prescribed by the Companies Act. Even if a founders' agreement provides that "the consent of all is required," this is merely an agreement between the parties, and it should be noted that it cannot legally dispense with or replace resolutions of the shareholders' meeting or the board of directors required by law. Nor is the authority to make all day-to-day business decisions determined solely by the shareholders' shareholding ratios. It is appropriate to understand a founders' agreement as setting internal rules on how the founders will run the company, on the premise of the rules under the law.

Adjusting Clauses with the Next Financing in Mind

When entering into a founders' agreement before a financing, it is also necessary to keep in mind its relationship with the investment agreement and shareholders' agreement to be entered into with future investors. In financings from Series A onward, it is common to set out with investors matters such as rights to subscribe for new shares, preemptive rights, veto rights and matters requiring prior approval.

If arrangements that conflict with these are created in advance in the founders' agreement, the company will be forced to amend or abolish those clauses at the time of the financing. For example, if the purchasers of shares on a founder's departure are limited to the other founders, a conflict may arise with the rights of first refusal and co-sale rights held by investors. Likewise, if the founders are obliged to reach unanimity on all important matters, the question of how to reconcile this with the investors' veto rights and the matters reserved for board resolutions will become a point of discussion.

A founders' agreement is also reviewed when financings take place or the composition of the founders changes. It is prepared at the seed stage as the company's foundation and reviewed as financings such as a Series A progress, in harmony with the investment agreements. If the founders have agreed on their basic thinking in advance, they can calmly explain the company's policy in negotiations with investors as well. A major value of preparing early lies in avoiding a situation where, without having decided anything, the founders are pointed out issues by investors and have to hurriedly discuss arrangements among themselves under the severe time constraints of a financing. The details of our support, including checking the consistency between a founders' agreement and investment agreements, can be found at Startup Legal and Financing Support.