A preliminary step before discussing venture capital, investments, and startups is the crucial stage of drafting the founders' agreement. This is an agreement that is usually made between the founders before establishing the company, for the purpose of establishing it, or shortly after its incorporation (some ventures are set up as partnerships, but this is extremely rare). The founders' agreement is one of the most significant agreements in a company's lifecycle and is of paramount importance because it regulates the relationship between the founders before and throughout the company's existence. It governs how the company is operated at the stage when the founders are the only ones involved, determines their exit options from the venture, and regulates the division of equity in such a case. The agreement also sets out how disputes between the founders will be resolved.

The company's management structure and roles within the agreement formally establish the responsibilities of each founder (even though, in practice, founders typically divide responsibilities among themselves, with some overlap). The agreement also establishes a cut-off point—the moment when founders, if they are still combining their company role with another job, will leave that job and dedicate themselves exclusively to the company (it is often agreed that this will happen after a certain funding round). Additionally, the agreement defines the initial board composition, usually granting each founder the right to appoint a director. It is advisable to have an odd number of directors if there is an even number of founders to prevent a deadlock (Deadlock). One possible solution is to add a director who will be appointed by unanimous agreement of the founders or an independent director from the industry in which the company operates (also appointed by unanimous agreement of the founders).

A founders' agreement will typically include various exit mechanisms. That is, how the relationship between the founders should function when one of them wishes to sell their stake to a third party or when a dispute arises that can only be resolved by the departure of one of the founders. These mechanisms often include Right of First Refusal (ROFR), Right of First Offer (ROFO), and Co-Sale Rights (Tag Along), which will be discussed in the context of the company's Articles of Association in future posts (in the Articles, these rights apply to all shareholders and the company, whereas in the founders' agreement, they apply only among the founders).

Another mechanism that sometimes appears in a founders' agreement is the BMBY (Buy Me Buy You) clause. This is a rather aggressive mechanism (which is why in the U.S., it is sometimes referred to as a Shotgun Clause or Texas Shootout Provision). The mechanism works as follows: Once triggered, each party has a set period to estimate the value of the venture. Shortly thereafter (in agreements I draft, this is usually one to two weeks after the clause is activated), each side submits a bid for the other party's shares to a neutral third party. The highest bid wins, allowing the offering party to retain their stake in the venture while purchasing the other party's shares at the submitted bid price. The main issue with this mechanism is that, while it theoretically ensures a fair market valuation (since each party submits what they believe to be a fair offer, often with a premium), it mainly favors the more financially capable founder, enabling them to buy out the less wealthy one.

The repurchase mechanism (also referred to as reverse vesting) grants the company or the remaining founders the right to repurchase or forfeit a departing founder's shares at a nominal price if they leave before a certain period has elapsed (typically two to four years from the signing of the founders' agreement or the company's incorporation). This is a very common mechanism with two primary purposes: first, ensuring that founders remain committed to the venture for the long term; and second, making sure that, if a founder departs, their equity can be used by the company and the remaining founders to incentivize a replacement. Such mechanisms are often required by investors—especially in early funding rounds. If the founders' agreement mechanism has expired or is close to expiring, investors may demand that founders sign a repurchase agreement to reinstate these protections. A similar mechanism can appear in exit events to retain founders in the company, known as a holdback clause. These mechanisms have critical tax implications if not properly drafted or if they do not align with current tax regulations. Therefore, it is essential to involve the right professionals in their drafting.

When it comes to startups, intellectual property (IP) is the most valuable asset. Investors often say they invest in the team and the people, but in practice, we have seen many deals collapse because founders did not adequately secure their IP rights or waived certain rights in commercial agreements. A standard clause in founders' agreements is the assignment of IP rights to the company. In legal terms, this means that all relevant intellectual property is transferred to the company’s ownership. This is crucial because investors want to ensure that the company, not individual founders, owns its core assets.

As part of the agreement, the founders also commit to confidentiality regarding the company’s affairs, avoid conflicts of interest, and agree not to compete with the company’s business (this is especially relevant when there are passive founders).

Because founders invest significant time and effort in their ventures—often making it their entire world—decision-making processes are critical. Typically, in any founding team, there is one founder with a managerial orientation who handles day-to-day company operations. However, for major company decisions, it is customary to require unanimous consent for certain actions, such as raising capital (though agreements often set a threshold above which only majority approval is required), approving an exit (similarly, a threshold can be set where very high offers require only majority approval), changes to the board composition, amendments to the Articles of Association, dividend distribution, adoption of an option plan, dissolution of the company, public offering (IPO), replacing the company's CEO, among others.

We will discuss representations and warranties in detail when covering investment agreements, but for the purposes of the founders' agreement, it is important to note that founders provide representations regarding their ownership of IP. In other words, founders commit that all intellectual property they contribute to the venture is either owned by them or properly licensed and that no third party has any rights over it. At this point, a highly technical founder might ask: "Wait, what about Open Source code?" The answer: It depends, and each case must be examined individually. Some open-source licenses may not pose a problem if used cautiously. We will cover open-source issues in a future discussion.