Business Law & Compliance

The advantages and disadvantages of having a founders’ agreement

6 min read

26 January 2018

Should SME employers have a founders’ agreement? As lawyers we would answer in the affirmative. The question then is: “What should be included in the agreement?”

As a business owner this is not a simple question and it often requires a fine balance between obtaining necessary protection for your business and reducing the scope for disputes, whilst allowing the effective management of a growing company and avoiding incurring unnecessary legal costs. But what are the advantages and disadvantages of having a founders’ agreement?

Worst case first

When businesses are first established, everyone involved is focused on the opportunities and the journey ahead, and fostered relationships are expected to survive bumps in the road. Whilst it is good to be positive and to plan for success, part of that planning must be to consider potential pitfalls too. What happens if things don’t go to plan? What if I fall out with my business partner? How will I protect myself and the business?

By considering potential issues and discussing them openly with your business partner you can form a clearer idea of whether and how to proceed. There are many potential sources of tension and failing to consider them upfront can leave a business in tatters later.

Examples might include the founders failing to grow with the business, perhaps becoming bored or disillusioned with the rate of progress. There may be a disagreement over the direction of the business or whether to risk capital investment rather than growing organically.

Align your expectations

The terms founders’ agreement and shareholders’ agreement are often used interchangeably. Essentially, a founders’ agreement looks to establish the basics such as the roles and responsibilities of the founding team, equity ownership and vesting and IP ownership.

A founders’ agreement is simply a form of shareholders’ agreement suitable at the early stage for the founders and will typically be replaced by a more complicated shareholders’ agreement when the business takes on more shareholders.

Business partners should discuss and align their expectations before putting suitably tailored agreements in place.

If you don’t have any agreements in place it can be harder (and more costly) to navigate difficult issues when they arise. Your partner could walk away and compete using the business’ knowledge and know-how. Alternatively, you may find your partner steps back and leaves you running the business, whilst they reap the rewards of your labour. Neither position is desirable. Failing to plan for the future can jeopardise your business before you start.

Whilst company law provides some rules for the governance and administration of a company, we invariably recommend entering into agreements at an early stage with dove-tailed articles of association that are well-structured to set out clearly:

• The management and decision-making at director and shareholder level including how deadlocks will be resolved;
• The rights (if any) shareholders have to financial and other information;
• Whether there is a dividend policy or whether dividends are paid at the director’s discretion;
• Whether different classes of shares are needed;
• Whether (and how) new shares can be issued, existing shares transferred and whether there will be pre-emption rights;
• What will happen in a sale – can a majority of shareholders oblige a minority to sell and can a minority tag along with a sale by the majority; and
• How the business will be protected: service agreements, restrictive covenants, intellectual property ownership clauses and confidentiality obligations.

The precise form of agreements may be driven by issues such as confidentiality, the number of parties, any external funding received and any expectation of a future change to the shareholders resulting from transfers or new investment.

Evolution over time

Whilst a founders’ agreement should be in place at an early stage, it is likely to need to be replaced as the business grows and takes external investment. The form of investment will dictate the structure of a new shareholders’ agreement. Equity investors will likely require board representation, investor protections and the provision of regular detailed financial information so that they can protect their investment.

Disadvantages of having agreements in place

There are very few disadvantages to having agreements in place and those that exist often arise from having agreements that are not suitably tailored to the business or lack precision. Being overly prescriptive can stifle a business, whilst an imprecise agreement can lead to disputes. Caution and suitable advice are therefore needed here.

If the above points are taken into account, though, a properly tailored founders’ agreement gives founders a firm footing for their business relationship and the future growth of their company.

Nick Atkins is a partner, and Katie Philipson is senior associate at Stevens & Bolton LLP