This article is part of a series covering topics related to starting a new business. It can serve as a jumping off point for consultations with an experienced attorney.
Summary: When a new business is about to be formed – particularly if it involves more than one founder – many decisions should not be left “to be determined.” These decisions relate to: how the company will be managed; the roles and responsibilities of the founders; possible restrictions on ownership and ownership transfers; how to deal with “ghost” founders; how to allocate profits and losses; and, how to resolve disputes.
To ensure the venture’s success, it is essential that those decisions be made before undertaking any major operations, and they must also be memorialized with the appropriate documentation.
Note: This article is applicable to both limited liability companies and corporations. The words “venture,” “company” and “business” are used interchangeably to refer to both. Likewise, “founder” and “owner” are also used interchangeably.
The Documents and the Deal
In order for the founders of a new venture to formally outline their “deal,” a range of documents may be required – depending on the intended business structure. For example, a corporation would need a Certificate of Incorporation, Bylaws, a Stock Purchase Agreement, and a Shareholders Agreement. A limited liability company structure uses Articles of Organization and an Operating Agreement. And there are other documents – such as employment agreements, confidentiality agreements, and non-compete agreements, to name a few – that also outline the founders’ deal. Some founders who have yet to even form a legal entity might also consider a pre-formation Founders Agreement to document their deal.
But why so many documents? And what is meant by “the deal” among the founders?
Business Purpose
One part of the deal includes reaching a consensus on the specific purpose of the business. Failure to agree on this fundamental point can doom a new venture. Such a consensus includes agreement on what the company’s specific product line or services to be offered will be, as well as the covered territory or expansion plans. Also, one founder might see the venture as a long-term endeavor, while another sees it as a short-term endeavor to be liquidated sooner rather than later. Though it might seem a given that founders would be on the same page on such matters, sometimes they’re worlds apart.
Management
At the outset, it’s also important the company’s founders spend time focusing on how they want the company to be managed. Indeed, the owners of many new businesses often assume several roles – including the role of managing the company. But that fact should not preclude them from spelling out the precise details of that management arrangement. Using the corporate business structure as an example, the founders should establish:
- How many individuals will be on the Board of Directors (Note: always have an odd number to avoid tie votes);
- If there will be any “independent” Board members who are not founders.
- Who will be the Officers appointed to manage the company’s day-to-day affairs.
- Whether outside managers should be brought in if industry experience is needed.
Similar issues arise when an LLC is used, though with different titles and somewhat more flexible management structures.
With that said, once the founders reach an agreement on how the company is to be managed, they must then consider if certain “major” decisions can only be approved by a majority, supermajority, or unanimous vote of those holding ownership interests in the company. Such major decisions could include:
- Selling, merging, or dissolving the company;
- Selling a major asset of the company;
- Undertaking major expenditures exceeding a certain dollar amount (e.g., $10,000); and
- Hiring or firing a CEO.
The Roles and Responsibilities of the Founders
It’s also important to define the roles, responsibilities, and time commitment expected of each founder. For example, since some founders likely enjoy certain core competencies that brought them to the table in the first place, do the other founders expect them to spend their time focusing on, say, product or service management?; technical or design control?; or perhaps marketing and sales?
Additionally, might one founder be expected to function as CEO? It’s also often assumed – though not always explicitly stated – that one individual will maintain the company’s books and records. Who will that be? Likewise, if a founder is to be hired as an employee in connection with these or other functions, the exact position and its associated duties, as well as the salary and other compensation – such as additional equity, options, or other benefits – must be established. Also, consider how, and under what circumstances, can a founder be removed from an employee position? All these decisions must be made early on and set forth in the appropriate documentation.
Non-Competition and IP Infringement
On another front, the founders must also outline if and how they want to prohibit each other from competing with the company, soliciting customers or employees, or revealing trade secrets or other confidential information, both during and after their tenure with the company.
On the flip side, many begin new ventures while working for another company, or after having left another firm. Thus, it’s imperative the founders safeguard that no activities of any founder violate any agreements they may have with third parties. This point is especially important with respect to any activities relating to IP that has been created for, or contributed to the venture. As these activities may raise non-compete, non-solicitation, or IP infringement issues.
Company Ownership
When you have more than one company founder, the issue of the split of ownership percentages is a major consideration. The founders – who are often the only “owners” in the early stages – must be in total agreement on those percentages. But what if the founder who had the business “idea” believes she’s entitled to 90% ownership while another founder who brought in most of the money believes he gets 90%? That could create a real conundrum because those percentages affect: 1) the amount of control and say in company decisions that any given owner enjoys; and 2) that owner’s allocation of profits and losses.
Thus, the founders must also be in full agreement on how to determine the value of their contributions to the company. This will prove vital in reaching, for example, an agreed to valuation of the “idea” founder’s contribution – which in turn will help them all move towards a consensus on the proper ownership percentage allocation. Similar issues will arise when it’s necessary to determine the overall worth of the company, thus again underscoring the need for agreed to valuation methods early on.
Pre-emptive and Special Voting Rights, and Transfer Restrictions
There also exist more complex ownership interest-related considerations worthy of mention, though they’re not always applicable to every new company. To begin with, some founders might be concerned about a dilution of their ownership percentage if future owners/investors enter the picture. In those circumstances, the founders might want pre-emptive rights that effectively enable an owner to “maintain” his or her initial ownership percentage. Some may also want special voting rights to have more of a say on certain matters. Founders could also agree to incentivize and encourage loyalty with vesting arrangements. In the case of a corporation, these generally involve granting a recipient of stock or options certain non-forfeitable rights that mature, or “vest” down the road based on predetermined schedules and milestones.
More issues may arise if a founder wants to sell his or her ownership interest. In that case, the non-selling founders may be concerned about company ownership falling into the hands of third parties that they do not want involved in the business. Transfer restrictions, can be used to solve this issue. Such restrictions include rights of first offer and rights of first refusal. Those rights – again using a corporation as an example – essentially require shareholders to offer to sell their shares to fellow shareholders before they can sell them to third parties. There also exist drag along rights that can actually force other owners to join a stock sale, and tag along rights that create a right to be included in a stock sale.
Some transfer restrictions often contain triggering events. For example, if a founder dies, becomes incapacitated, or files for bankruptcy, that could give rise to the right of the company or the other founders to buy back an affected founder’s shares. A similar scenario can arise if a founder were to leave the company – though again, the founders must agree on these terms long before the triggering events might occur.
Ghost Founders
The founders must also be vigilant that no ghost founders are lurking who might later claim an ownership interest based on contributions they claim they made in the early stage. If there are ghost founders, the actual founders must agree on how to deal with them sooner, rather than later, since they tend to reappear at inopportune moments, such as during a critical financing.
Contributions, Profit Allocations, and Intellectual Property
There should also be no ambiguity on what funds or other assets each founder will contribute or invest at formation and in the future. If certain funds are only intended to be in the form of a loan, that must be documented. Also, if certain assets include intellectual property, the founders should also agree on who will own that IP. If the IP is to be owned by the company, the founders must also decide at formation whether or not it will revert back to its original creator if he or she is terminated.
Contemplating the venture’s future funding and financing plans at the outset is also essential. Most importantly, the founders must ensure – while working with the company’s attorney – that none of the documents being drafted contain any provisions that might jeopardize those contemplated funding and financing plans.
With respect to the allocation of profits and losses, in the basic corporation structure, those allocations essentially line up with ownership percentages. With an LLC, by contrast, the remarkably flexible Operating Agreement can provide that profits and losses be allocated in a manner the founders negotiate. Many states, like New York, have LLC statutes with “default” rules concerning such matters if the Operating Agreement is silent on the point. Therefore, unless LLC founders want the default rules to govern, they must agree on the allocation issue at formation. Finally, less than straightforward profit and loss allocations should only be settled on after consulting with a tax professional and CPA.
Dispute Resolution Mechanisms to Reduce the Risk of Litigation
Nailing down the deal among the founders will certainly go a long way in minimizing potential disputes. However, as opinions, goals, and circumstances change over time, disputes may still arise. Therefore, new venture founders who have the foresight to also implement internal dispute resolution mechanisms beforehand can greatly minimize the risk of costly litigation.
One such mechanism includes adopting a mandate and corresponding procedures to require the use of mediation to resolve conflicts before litigation or arbitration can be pursued. Indeed, mediation can sometimes serve as a “release valve” that allows for the airing of grievances – which is sometimes the disputants’ real objective.
However, even with mediation mechanisms in place, the founders need to also agree, at the time of formation, on other important dispute resolution-related items that can be implemented if mediation turns out to not have smoothed out a given conflict. Those items include agreeing on the forum (i.e. the court that will have jurisdiction) and location where future judicial proceedings are to take place. Agreement must also be reached on which state’s law will govern such disputes, particularly if founders are from different parts of the country.
Separate Counsel
The founders should also be aware that the attorney drafting any of the above-mentioned documents is typically only looking out for the best interests of the company, and not those of any one founder. Indeed, that’s the ethical duty of the “company lawyer.” Thus, though it might seem a bit onerous, it may be necessary for some founders to retain their own legal advisor before entering into certain agreements. This is particularly the case in more complex undertakings, or, when a founder’s interests might be diametrically opposed to those of the company, such as with a non-compete agreement.
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Our judicial system is chock-full of business-related disputes where everyone founders initially thought they were all on the same page, only to discover they were worlds apart. Thus, when undertaking a new venture, no time should be wasted when it comes to ironing out “the deal” among the founders.
