What co-founders need to do to clear the air before collaborating
You have an idea. A brilliant one. It has the potential for a lucrative business and will, of course, attract investors. You want to start working on it immediately. You will need someone to work with you. You are happy calling that person a co-founder. What next?
Starting a business is not difficult anymore. People from diverse backgrounds and age groups have managed to become entrepreneurs. The tough part, however, is to sustain a business and scale it up. From a legal perspective, there are multiple aspects that have to be considered. Choice of entity, protecting intellectual property, retaining and incentivising talented employees are all important decisions and critical to a startup’s growth. However, before evaluating any of the above, it is important for founders to think about aspects of running a business that are often presumed or not spoken about (at least not in too much detail). The aim of this article is to focus on the first discussions that should take place between founders before they formally set up an entity or take the deep dive into the startup ecosystem.
In my experience, a lot of tough questions are always discussed very generally amongst founders without getting into too much detail. They hope to tackle them as and when the need arises. Till then, they want to focus on the business and not worry about hypothetical possibilities. Principally, I completely agree with this approach. There are enough startup founders in the market who never had awkward discussions with each other and are now running very successful ventures. But, at the same time, there are also founders who chose not to discuss their role, contribution or vision, only to get stuck in conflicts and ego clashes. Below are a list of questions/pointers that should be discussed and debated amongst founders (and perhaps even be put up by investors) ideally before they agree to collaborate and kick start their venture. So here goes:
- At the very outset, it is important to understand the short-term and long-term goals that each founder has for the venture as well as for themselves. I would encourage founders to write these down and share them with each other. This will give the first input on where each founder stands and whether, in fact, their visions are aligned.
- What is the strength of each founder? Do the strengths complement each other? What strength does one founder think the other is bringing to the table?
- Is any founder in the business only a “financial investor” or will he/she be actively involved in running and operating the venture? Will all founders work full time towards the venture? Often founders share equal responsibility and divide work amongst them. However, there are also instances where one works a lot more than the other but both are compensated equally (either in terms of salary or equity). Therefore, it is important to understand, evaluate and then define roles and responsibilities.
- If the intent is to set up a private limited company, how many people will be on the board? If it is an even number, what happens if there is a deadlock in the decision making? Under Indian law, unless anything contrary is mentioned in the Articles of Association, the chairperson of the meeting has a second and casting vote. So, who will chair the meetings and why?
- Will the founders get any salary? How will the compensation package be determined in the short term and long term? Are you looking to set up an ESOP pool? Bear in mind, promoters of a private limited as well as directors holding more than 10 per cent of the outstanding capital cannot be given stock options under an ESOP scheme. So, the compensation details should be thought through clearly, especially if there will be significant variation in the job profiles of the founders. (Tip: As a founder, don’t commit ESOPs to any employee till you have not approved an ESOP scheme in a shareholders meeting and filled the necessary forms with the Registrar of Companies).
- Can the startup operate without any of the founders in the future? Is any founder looking to exit in the near future or are all equally passionate about staying in the venture?
- Going forward, would the founders always like to retain control of the venture or would they be willing to share it with investors/mentors? What, according to the founders, are the pros and cons of sharing control with external investors?
- How does each founder believe the venture will make money and why do they believe the business will attract investors? What is the one aspect of the venture which is indispensible?
- At what threshold of the business does each founder believe they will require external funding? What type of investors would the founders be interested in getting on board? (Tip: Sometimes it is better to get good investors on board at slightly lower valuations rather than a bad investor at a higher valuation).
- In case the co-founders are friends and have known each other for a while, then this last question is important, though often not taken seriously. Have the founders had any disagreements and fights in the past regarding anything - sports, food, friends, relationships, family? If yes, how have they been resolved?
Clarity and discussions on the above will go a long way in understanding how the Founders Agreement/Shareholders’ Agreement should be drafted and also ensure that all founders are on the same page going forward. This will not only safeguard their personal interests but also that of the venture.
In my second post, I will discuss the various entity structures and aspects that founders should consider before deciding on what entity to set up. I will write about intellectual property and highlight some key mistakes that startups make protecting or defending their IP. My fourth post will be about key terms in a term sheet, their meanings and how they should be negotiated. Finally, the fifth post will analyze post-funding (or post closing) compliances that startups should do (ESOPs, RBI filings, etc) which they often ignore (or forget) once the bank account is credited with dollars.