Year 2012: Locon Solutions Private Limited flagship brand Housing.com starts operation from the beautiful campus of IIT Bombay. Twelve students come together to develop an online portal with the vision to simplify the daunting task of house hunting. The project is an instant success. Traffic increases, so does funds. Within two years the company is valued at Rs. 300 Crores and has four rounds of funding from top investors.
Year 2014: The Economic Times runs a front page story that three co-founders have quit Housing.com since 2012. (The Economic Times, Bangalore Edition, August 05, 2014)
The question is what happens to the company when co-founders leave?? The answer to this question is extremely important and worrisome for the remaining people in the company, as well as the company’s investors, as is evident from the story in the papers. And the answer lies partly in having a Founders’ Agreement!! Housing.com is a classic example that stresses on the conscious need to have a Founders’ Agreement among all the co-founding partners.
Over the past year, I have come across at least five mandates where there is a dispute within the founders and directors of a company. In some of them, the company has done extremely well and has scaled. And now the founders want to part ways. The reasons for this could be multi-fold – maybe there is a clash in the vision; or boost in the confidence of one co-founders that he can do better, thereby generating higher profits for himself. Or there’s just a change in individual priorities.
The trends show that entrepreneurship is increasingly being taken up by college students. The popularity of accelerator programs and incubators in colleges often provides the required platform for budding entrepreneurs. Sops like the proposed ‘Rs. 10,000 Crore startup fund’ only encourage the students to jump into entrepreneurship. And we always have Mark Zuckerberg and the Bansals of the startup world!! But then as one progresses in life, priorities do change. It is not always easy to forego a fat paying job at the end of college. Some choose to go ahead for further studies. Others become unfortunate victims of social and family circumstances. All-in-all what suffers is the great idea that the entrepreneurship journey was started with. Even Phanindra Sama (Co-founder, RedBus) agrees that Indian companies do struggle with managing co-founders and that three of the seven initial co-founding members quit RedBus within one year of its inception.
One of the major issues with co-founders quitting is the impact on the shareholding pattern of the company. If the organisation does not completely disintegrate and the remaining people in the startup intend to continue with the company, the last thing they would want is the exiting co-founder handing over his stake to a third-party / outsider. At this juncture, I would lay emphasis (assuming the organisation structure is a private limited company) on the need for having a strong set of charter documents of the company i.e. the Memorandum of Association; and the Articles of Association, which contain the bye-laws that govern the functioning of a company. If proper attention has been paid to effective drafting of the charter documents, damage can be mitigated as most charter documents in a private limited company would have a restriction on free transferability of the shares of the company. This often flows from the Founders’ Agreement / shareholders’ agreement, if any. Accordingly, it is advisable to categorically address the issue of exit of co-founders in any eventuality. This can be typically done by agreeing on the inclusion of a Right of First Refusal clause in a Founders’ Agreement. What this provides for is a right to the continuing shareholders of a company that an exiting shareholder will first offer his shares in the company to the continuing shareholders, and only in the event that the continuing shareholders refuse to buy him out, can he offer his stake to an outsider.
Housing.com had twelve co-founders, but only two directors. It is the directors of a company who are in control of the company. Unless shareholders cumulatively holding a majority of the shares of the company (preferably above 75%) come together, it will be difficult for individual shareholders to have their say in the company. This often leads to friction. This could affect the operations and growth prospects of the company. It is because of this reason why it is advisable to have a Founders’ Agreement categorically setting out the responsibilities of all co-founding members, as well as a sound dispute redressal mechanism. The later is all the more important since internal conflict in a company affects the goodwill of the company and is a huge deterrent for prospective investors, which in turn jeopardises the growth of the company.
Investment funding is extremely important for the phased growth of a company. We all know about Flipkart and the $1 Billion story!! One of the key issues that come with organisations having unrelated co-founders is - who will dilute his shareholding in the event the company is raising funds? Remember how Eduardo Saverin was diluted to less than 5% in Facebook, and the subsequent law suit? The issue of shareholding dilution also comes into picture during earmarking for ESOPs for the employees of the company. In the event ESOP is not provisioned for at the very inception, there is bound to be a conflict between co-founders as to who will dilute, and in what proportion at the time of ESOP awards. Accordingly, it is always advisable to categorically set out a clause on dilution proportionality in the Founders’ Agreement.
Last, but not the least, an ex co-founder starting a competing business is a never welcome development. This brings us to the point of non-compete and non-solicit clauses in a Founders’ Agreement. A non-compete clause typically restricts an exiting co-founder from setting up a competing business in the same industry. Under the current legal regime, a non-compete clause may be a bit difficult to enforce in a court of law (it may considered to be an ‘agreement in restraint of trade’ and hit by Section 27 of the Indian Contract Act, 1872). However, the same is subject to the facts of each case, and is hence a popular clause in Founders’ Agreements and employment agreements. Similarly, it is advisable to include a clause restricting the exiting co-founder from soliciting your current employees, in the absence of which, your employees maybe engaged by an exiting co-founder who may go on to become a competitor. Also, on a parallel note, as already discussed, it is advisable to incorporate a ‘non-compete’ clause in the general employment agreement that is executed between a company and its employees.
The best of business houses have had their share of tussles. The Ambanis, Birlas, Kirloskars.. all of them have had management issues. The Flipkarts and Snapdeals of today are the powerful business houses of tomorrow.
While trust is the fundamental foundation of any successful relationship, it’s always mature to separate personal and professional lives. It is always advisable to have a Founders’ Agreement. This could go a long way in boosting the growth of a company!!
[Update] As per the information filled by the company with the regulators as on date, there are only 2 directors in Housing.com.
About the guest author:
Prateek Mohapatra is a corporate lawyer associated with one of the top law firms of the country. Prateek has a keen interest in the startup space and regularly interacts with and advises entrepreneurs on different aspects of doing business in India. He can be reached at email@example.com.
Disclaimer: The views & opinions expressed in this post are those of the guest author and do not necessarily reflect the opinions and views of YourStory.com.