By Naina Krishna MurthyManaging PartnerKrishnamurthy & Co.

Founders’ Agreements

Monday, 28th October, 2013

A Critical Start for a Start-Up

Agenda

o The three questions on Founders’ Agreemento The constituents of a Founders’ Agreement• Standard Terms• Board Constitution• Contributions• Vesting and Control• Transfer Restrictions• Intellectual Property Rights and Promoter Covenants• Termination and Jurisdiction

o Watch Out Issueso Questions?

How many Entrepreneurs in the room believe that a Founders’ Agreement executed orally

is legally enforceable?

QUICK POLL

The Three Questions on Founders’ Agreements

What is a Founders’ Agreement: A contract between founders/promoters of a businessooutlining mutual understanding and setting out expectations of each partyostreamlining investment and distribution of money and highlighting roles, responsibilities and obligations of each party

Why do we need a Founders’ Agreements:o to record understanding in order to avoid any ambiguity in futureo to set expectations, align goals and assign responsibilities

oTo provide for contribution, allocation and distribution of resourcesoTo pre-empt possible hurdles and identify ways to tackle them

It is Advisable to enter into a written agreement to avoid ambiguity in enforcing oral contracts. Further, the agreement should ideally be entered into at the incorporation stage since there would be some amount of investment of time and money by then.

The Three Questions on Founders’ Agreements

When to enter into a Founders’ Agreement:oIdeation stageoIncorporation stageoCapitalization stage

Can an investor force a founder to sell his/her shareholding in the start up?

QUICK POLL

oStandard Terms of a Founders’ Agreement

• Equity Investment and Capital Structure• Board Management and Deadlock • Shareholders’ Meeting• Fresh Issue and Transfer Restrictions• Vesting• Business, Business Plan, Accounts and Policies• Confidentiality, Non-compete and Non-solicit• Representation and Warranties• Indemnity• Termination and Consequences• Governing Law and Dispute Resolution• Boiler Plates

The constituents of a Founders’ Agreements

• Advisable to have a legal entity in place before money and business ideas are brought to the table

• Company is a commonly preferred structure

Board Constitution

oOptimum Board Structure - a balancing act

•What should be the size of the Board/Odd number structures

•Will all the founders be on the Board•Who will be the Chairman of the Board and will the Chairman have veto rights•Unanimous Voting Rights

QUICK POLL

Does the Indian legal system allow individuals to take an equity stake in a start up by making contributions in

kind?

oContribution – Nature and Nurture

•Employee or shareholder or both•What will be the form of contribution by a founder – cash or kind•How would you value non cash contribution•How will the shareholding be distributed amongst founders•How much are the founders willing to dilute in the future

• Minimum shareholding/capitalization requirements under the law

• Valuation of assets/intangibles important from tax perspective

• Incase of foreign founders, contribution has to be in cash or against lump-sum payment/royalty

Contribution

QUICK POLL

Can an angel investor with 10% shareholding, prevent a start up from taking money from a VC in the next round?

oOwnership / Control - Shareholding Control

•Will all shares be allotted upfront or will there be milestones based on which shares are vested•What are the different possible dilution events •What is the extent of dilution•Should a shareholder be given veto rights•Pre-emptive rights•Enforceability

• Control rights available under the law at different levels of shareholding (Discussed in the next slide)

• Minority shareholders are given protection under law

Vesting and Control

Shareholding Level of control over Indian Company

<10% A derivative action in the name of the shareholder to the Court of Law on behalf of the Company.

10% - 25% Minority protection rights for relief against oppression and mismanagement.

25.01% - 49.99%

Can block matters requiring a special resolution (75% voting in favour), which include alteration of Charter Documents, amalgamation and mergers, preferential issues of shares, other rights stipulated in the Articles.

50% Can block all resolutions requiring approval of shareholders by ordinary resolution.

50.01% - 74.99%

Has majority rights and control over matters requiring ordinary resolution (simple majority), which include the appointment of directors, declaration of dividends, appointment of auditors, issue of shares on a rights basis, etc.

75% - 89.99% Has the ability to pass both ordinary and special resolutions.

90.01% Has effectively full control since minority protection is generally available to shareholders holding 10% or more shareholding.

Vesting and Control

o Restrictions on transferability

• Should there be a lock-in?• What happens if a founder wants

to sell his stake?• Right of First Refusal/Offer• Tag Along Rights• Drag Along Rights• Transfer upon death or termination

of Agreement

In case of private limited companies, these are contractual rights

Transfer Restrictions

QUICK POLL

How many Founders here think that the ownership of the IP developed by the

founder/employee of a start-up, will vest in the start up?

oIntellectual Property Rights• Protection• OwnershipoPromoter Covenants• Exceptions• Non Compete Obligations• Compensation (whether cash or past

considerations)• Restriction as an employee vs. founder• Non-solicitation

Intellectual Property Rights & Promoter Covenants

oJurisdiction and Termination

• Jurisdiction of the Founders’ Agreement• Modes of Dispute Resolution• Circumstances for Termination• Consequences of Termination• Asset distribution post Termination• Restrictive Covenants

• Winding up proceedings could be time consuming

• Enforceability of non-compete restrictions amongst shareholders

• Distribution of capital

Jurisdiction and Termination

oEnsure that contract is valid and properly executedoExpressly provide for consideration oStamp the contract with applicable stamp dutyoProvide for severability of clauses not recognized

under Indian lawsoIncorporate provisions into Articles of Association

In case any party executing is a corporate entity, ensure that the entity has appropriate authority to enter into contract.

Watch-Out Issues

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