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Working with a co-founder – why your start-up needs a prenup

12 November 2018


Prenuptial agreements – also known as ‘prenups’ are still fairly uncommon in the UK, but when it comes to agreements between co-founders, they are absolutely essential.

Having a co-founder can be a fundamental boost to the fortunes of a company, providing a means of sharing the stress, decision-making, and successes.

But the ‘co-founder prenup’ can still be an uncomfortable topic to discuss, because it cuts to the quick of early co-founder relationships, and raises the unspoken fears of failure.

It’s not surprising, therefore, that these agreements are often viewed as a negative.

The point, says George Whitehead of Octopus Ventures, is that it’s vital to start a business on the front foot. When setting up a company, it is crucial to have the hard conversations first – and doing so can actually be a positive thing.

According to George, “Co-founder agreements are about the social contract between you and your business partner. It means you’ve considered all possible eventualities, and the legal point of view, at the beginning of your relationship, rather than having to deal with challenges reactively and potentially jeopardising the business.”

We wanted to understand why co-founder agreements are so important for early-stage companies and their founders, so we sat down with George and Alastair Peet, a corporate partner at law firm Shoosmiths, which specialises in advising companies that have secured venture capital (VC) and the investors who have backed them.

What is a co-founder agreement?

Co-founder, or shareholder, agreements usually refer to two things: the company’s articles of association, and a formal shareholder agreement, which together outline the ongoing relationship, and what happens when someone leaves the business and the treatment of their shareholding.

“The conversations around the creation of these documents will cover tough questions, like if and when founders would like to exit a business, raise money, or the size they would like to get to,” says George.

“These are significant decisions that will massively impact the day-to-day running of the company, but are vital in ensuring that you and your business partner are aligned in your goals and decision-making.”

Why they matter at the outset

Start-up founders can be put off getting to grips with shareholder agreements early on, and there are often concerns about complexity, relevance and cost. “Unfortunately, thinking like this is a false economy,” says Alastair.

“We might not like to hear it, but it is human nature to be swayed by money”

“Invariably, as a business grows and becomes more valuable, if rights are not laid out from day one, life will become increasingly more difficult. We might not like to hear it, but it is human nature to be swayed by money so, as founders work hard and build a successful business, they are increasing their risk of a fall if the correct documents are not in place.”

The documents don’t have to be very complicated.

Alastair explains that, for instance, a very young company may not need a full shareholder agreement in place from the beginning. “Articles of association can be written in a way that governs the things you need to think about at the very early stage, like who takes what if someone leaves, and what preemption rights are in place, should a founder wish to sell their shares.”

Moreover, most lawyers involved in the early stages of company development are mindful of exactly that, with flexibility around fee structures and the pace of business growth.

Clarification across the board

A key reason that getting things down on paper matters early on lies in the nuance of building a business. Founders may have strong personal reasons for leaving their company, or it may not be so simple as ‘you’ve done something bad for the business, so you have to go’.

“The earlier stage the business, often the more blurred the lines around people leaving and changing their minds on things,” says Alastair.

And many people will be familiar with the way in which co-founder agreements can help align founders around human resource (HR) matters.

They can provide some clarity, like ‘good leaver’ and ‘bad leaver’ provisions, which are designed to incentivise shareholders who work in the business to stay there, the allocation of new shares to leadership teams, and setting out who can appoint new directors.

But these agreements can also cover things that founders should find time to cover as they launch a business and settle on other shareholders.

“Make sure the people you are choosing to work with see things as you do. Founders can use this time to ensure full strategic alignment,” says George.

“And even then, plans will still change, which makes avoiding detail early on a double error.”

Another area where up-front attention to detail pays dividends is concerning intellectual property (IP). “Often, we’ll see intellectual property (IP) rights in the hands of the guys who have set up the company, and not owned by the company itself,” says Alastair.

“The issue here is that a co-founder could leave, the firm can’t use the IP, and suddenly the business is worthless. Or an investor could look at that company and think ‘the IP isn’t actually owned by the company, so the value isn’t there’.”

“As a co-founder, you want clarity”

Thinking in terms of investor readiness is a helpful way to prove the importance of co-founder agreements. Alastair recalls a client business founded by a group of academics.

By the time he started working with them, there were “lots of things they hadn’t dealt with”, like employment and insurance issues – things that should have been in place from day one.

“We were dealing with a VC deal, and it was quite a headache getting them comfortable with the business – because of issues that wouldn’t have come up had they not been shunted down the line.”

By the time a start-up goes for funding, it will have wanted to progress from having simply bespoke articles of association to a comprehensive shareholder agreement. “If there are third parties involved, whether that’s angels or VCs, then that’s when the shareholder agreement becomes vital,” explains Alastair.

VC term sheets come in all different shapes and sizes. While some will be more stringent, expecting founders to stay in the business in return for shares, others will be more relaxed about dilution and founders coming and going.

But any investor will want to know that the right provisions are in place, and that founders have taken the time to understand processes.

And clarity to satisfy third parties is just part of the justification for cracking on with co-founder agreements.

“Most of all, as a co-founder, you want clarity,” says George. “As a company grows, so does the scope for changing plans or differing views. Grey areas lead to uncertainty, and that can mean the business is effectively being held as ransom.

“Co-founder agreements can avoid that.”