Startups are tough bumpy rides and there would be a lot of hiccups. Infant death is attributed to weak management, indecisiveness, and mistrust amongst the founders.
Imagine someone constructing an apartment building. In the early days, there were no renters, so there was no revenue. The builder wants to save as much money as possible until the building is at least partially occupied, so he decides to save money on the foundation by leaving out the rebar – hoping he can come back and add it later. He finishes the building, and from the outside it looks just fine. Tenants start to move in and revenues increase. The builder now has the money to add the rebar to the foundation, but of course, it’s no longer possible. But it still looks fine. More tenants move in. The additional weight causes the foundation to crumble and the building to collapse.
The reason this is a good analogy is that many of the structural inadequacies in a company are also very difficult to fix after the company is launched – especially if there are external investors. The company will often still look just fine, often for years. But the flaws, like the missing rebar, are still there – genetic defects in the company’s DNA. Invisible failure mechanisms often cause the company to collapse.
Listed below are the reasons due to which most startups fail. Check our exclusive blog on Why do 9/10 startups fail brutally? Here are 10 ‘NOT TO DO’S’ for survival! explaining each reason in detail.
We can very well see one of the major reasons for the failure is Disharmony in team or Poor team management. How can you avoid that outcome? Many entrepreneurs and lawyers advise that, to protect each co-founder’s interest, creating a formal founders agreement should be a first step in establishing your relationship. However, to my understanding, this thing comes at a secondary position! Really? Then what comes first?? Here is the answer! To reach an agreement that’s fair and effective, you need to have potentially difficult conversations with your partner – before you begin writing. What should be the topics to discuss before writing a Founders Agreement?
- Compatibility: Don’t assume you’ll learn what you need to know about your partner as you work together. Make time to learn about your co-founder independent from work to discover if you’re compatible. For instance, do you see the glass as half-full or half-empty? Are you chronically late or always on time? Are you an early riser or a night owl?
You really have to force yourself to say, “Where do you want to be five years from now?” That doesn’t just mean socioeconomically, in terms of how much money you want to make. But where do you want to be in terms of your family? Where do you want to be geographically?
– Lara Hodgson
- Core-Values: Your startup’s culture builds upon your values. Unspoken differences in values can have a significant impact, affecting myriad decisions, such as where to seek investments, who to hire, when to hire, and how to structure your company.
- End-Game: What will you do if the business fails? what if your venture takes off and someone wants to acquire you? Will you agree? Would you sell for $50mn? Or are you hoping to scale the venture into a unicorn? Over what timeline? Hodgson observes, “some people will hang on forever because the company becomes a part of who they are”. It may seem awkward to discuss how you envision exiting as you launch, but these types of conversations are essential to developing a sound partnership.
Now, since you know the prerequisites, it’s time to discuss essential agreements to be in place right from the beginning to prevent structural failure due to flaws in Internal Corporate Governance starting with Founders Agreement which is the God of all other agreements at least in case of startups:
1. Founders Agreement
A Founders Agreement is a legal contract between the founders that defines roles, responsibility, shares of equity, exit options, etc. It is designed to protect each member’s interests and to prevent future conflicts. Think of the Founders Agreement as a form of “prenuptial agreement”. Below listed are the various clauses an ideal Founders Agreement should have:
> Equity Allocation
The most critical clause of a Founders Agreement is regarding the proportion of equity ownership of each co-founder of the startup. This clause mentions the consideration invested by a founder in the form of monetary investment, experience, network and IPRs.
The ownership clause specifies the number of shares owned by each founder, the total amount of capital invested by a co-founder, and division of profits between them. While performing equity allocation, define clear grounds as to how much weightage to be given to Cash v/s sweat v/s skills. A well defined corporate structure will smoothen the functioning of your business.
> Vesting Schedule
What if one of the founders becomes lenient after getting the equity. What if one of you wants to leave after a year or two? Does the leaving member keep his/her shares or have to surrender?
In the event of a surrender, how do the remaining members distribute those shares? What if you have to add a new member to the team?
The founder’s agreement should clearly define the vesting schedule to avoid future conflicts. This becomes even more critical when you raise funding from outside. You should also have a documented understanding of how and under what conditions these agreed-upon vesting terms can be modified. The founders’ agreement can include vesting of shares in the following ways:
- Time-Based Vesting: in proportion of the time spent by the founder.
- Milestone-Based Vesting: will take place when the company achieves a milestone.
> Roles & Responsibilities with Titles:
Planning to discuss your expectations for general roles & responsibilities and titles with your co-founder at an early stage can mitigate future conflict.
You can also stipulate that the roles will be re-evaluated periodically, such as every six months, and if necessary, redefine roles & responsibilities and titles to reflect changing needs.
> Decision Making with Rights
This section defines who holds final authority within different aspects of the business. Decisions would range from bringing investments, vesting equities, adding new people to the core team, termination and pivoting etc.
You can have a clear division of areas and ownership for business development, marketing, product development etc. The person who is owning a domain can have more power in that area, but a clear decision-making structure should be defined. Representing your company to outsiders, potential investors, bidders etc is a principal event which takes place in each startup at some or the other point. Founders shall additionally specify who will represent the company on the board, and stipulate observer rights for other founders. What happens if you disagree? Your Founders Agreement should also address how you will resolve disagreements and deadlock.
> Compensation
The agreement should clearly lay down the scheme of compensation in terms of which founder should get how much and how will the amount be determined?
Further the form of compensation is crucial which can include cash as fixed and/or variable, general equity, sweat equity, preferential equity, debentures, convertibles, warrants, bonds etc. At times, co-founders may make value additions in the form of bringing in intellectual property rights, technical know-how, marketing rights or similar value additions in the company. It is important that there is a clear understanding between the co-founders with respect to the monetary value of such value additions and the compensation to be paid to the co-founders for bringing in such value additions.
> Exit Strategy
Once you have started a company together, agree on the exit strategy now! In case a founder leaves the company, you might want to have the preferential right to buy their shares.
You will therefore need to agree how the price will be decided. The procedure for issuing new shares should also be laid down. All these issues should be discussed and put down in the agreement before commencing business to avoid unnecessary conflicts later on.
A classic example is that of Facebook. During the initial stages when Facebook required funding and was trying to attract investors, Mark Zuckerberg diluted the equity shareholding of one of its co-founder’s, Eduardo Saverin. This led to a bitter lawsuit, which is depicted in the movie The Social Network. Though the case was eventually settled, Saverin got 5% equity in the company, which he continues to hold.
Secure Intellectual Property Rights
If you are working in a high-tech domain, it’s possible that one of the founders had a major role in developing that product. He/she has all the right to be attached to their innovation, but any Trademark, Copyright or Patent should be owned by the company and not by an individual.
The innovator can be rewarded with higher equity or compensation if required but once you form an entity, everything is owned by the entity and not by an individual. This helps you protect the organization when an individual decides to break away. The founder should not claim a right over the product or develop a similar prototype with someone else.
> Transfer of Shares
The Founders Agreement must also state restrictions on co-founders regarding the transfer of their shares to any third party. This means that the agreement must state the lock-in period for which the founder is not permitted to transfer the shares owned by them in the company. The clause must also include the legal remedy that can be availed in case the co-founder breaches this clause.
> Fundraising
The Founders Agreement must also include the clause relating to fundraising and management of its finances, and the manner in which the loans of the business can be taken and repaid. Besides, define the process of decisions as to how much capital needs to be raised to scale up the business, when to approach funds, what stake in the company to offer to them, etc. Dilution can dramatically impact the value of your portfolio.
In his exclusive interview with Binny Bansal, the Flipkart man said, one of the biggest mistakes founders make is diluting their business to a huge extent during early rounds of funding. This leaves them with reduced share in their own business.
> Confidentiality and Non-Compete Clause
As a founder, you are expected to have access to all the confidential information. The core team should trust each other. What if one of the founders decides to leave and share the critical confidential information with one of your competitors?
Your agreement should have a binding time for any parting member. The parting members should not join competition, start a similar business, break away suppliers, vendors, employees, or clients.
> Dispute Resolution
What happens if one founder isn’t living up to expectations under the Founders Agreement? How is it resolved? Conflicts, Disputes, and Disagreements are a part of startup life.
Maturity lies in thinking ahead through the scenario, and agreeing and documenting a framework/process to resolve such a conflict. Decide the Court of jurisdiction in which your business will be addressed.
2. Form of Business
Corporations, LLCs, and LLPs etc. are formed by filing documents with appropriate state authorities. The costs for forming and operating these entities are often greater than for partnerships and sole proprietorships due to legal, tax, and accounting issues.
However, all of the entities generally offer significant advantages for founders (and subsequent investors) including, significant liability protection from business creditors, tax savings through deductions and other treatment only available to corporations and LLCs, and ease in raising capital in contrast to sole proprietorships and partnerships.
3. Forming Different SPVs
This is one of the key points on which most startups miss out. For instance your own beverages business having three main products A, B & C. After 7 years you want to sell Product B business as it is not a core area of focus. But how will you do it now? This will attract lots of complications as all your products are centered in a single entity.
In such cases, it is advisable to form different companies or SPVs (special purpose vehicles) for different business verticals. Hence when you decide to sell a particular segment, other businesses are not affected.
4. Employment Agreements
If your business is at the stage where you are hiring employees or contractors and freelancers, you will need to have employment or service contracts for each individual employee, which will specify duties and obligations of both your business as an employer and the employees you are hiring.
Certain crucial aspects that you shall include in an employment agreement are:
- The exact job title and duties of the employee.
- The compensation details including salary and benefits.
- The schedule for vesting of shares that you may wish to incentivize your employees after a certain amount of time with the business, in which case you would need to set this out in your agreement with them.
- Depending on the nature of work being provided, confidentiality of information, intellectual property, etc. This ensures any inventions, ideas, products, or services developed by the employee during the term of employment and related to the business belong to the company and not the employee.
5. Terms & Conditions and Privacy Policy
A term of use agreement sets forth the terms & conditions for people using your website. Your privacy policy is the legal statement on your website setting forth what you will do with the personal data (such as name, email, phone number, address, credit card number etc.) collected from users and customers of the site, and how such data may be used, sold, or released to third parties.
6. Standard Form of Contract
Almost every company should have a standard form of contract when dealing with customers or clients. But, there really isn’t a “standard form of contract,” as every contract can be tailored to be more favorable to one side or the other.
The key is to start with your form of contract, and hope the other side doesn’t negotiate it much. Make sure you have clearly spelled out pricing, when payment is due, and what penalties or interest is owed if payment isn’t made. Include limitations on your liability if the product or service doesn’t meet expectations or if unforeseen events occur. Also Include a clause on how disputes will be resolved.
Conclusion
Structuring errors often cause companies to fail. The most heartbreaking examples are when the company continues for several years, often showing great promise, and then the structuring flaws, built in during the startup phase, cause it to collapse. Besides, in the absence of above agreements, an investor may not be very keen to put his money in a startup which does not have a formal system of management agreed to by its founders. But now you know how you can avoid such big legal mistakes before starting to gear up. However it is essential to get it verified if your startup is on the right track. Many founder have got their startups screened with Check My StartUP.
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To ensure strong Internal Corporate Governance and enhance the success of your startup, you can get it checked from Transparent Capital partners. We, at Transparent guide the founders with most innovative and worldwide proven scientific process by utilising the 200+ years of collective experience of our team.
Have you ever faced bottlenecks due to non consideration of above governance issues or do you know any business which failed brutally due to these issues?Share with us your thoughts & experience on the above.
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