The end of gentlemen's agreements- the importance of founders' agreements for early-stage companies

From a short inscription on the back of an envelope, to a mere handshake – business has been conducted without formal written agreements in place since time immemorial. Though technically fine in principle, in that valid verbal agreements are legally binding in England and Wales, issues may arise when seeking to enforce such informal “gentlemen’s agreements” dependent on trust and goodwill alone.

A leap of faith

As founders, the potential success of your venture often involves taking a stark leap of faith into the unknown. Indeed, the majority of prosperous business ventures are those that seek to plug the gap and provide innovative solutions to previously unanswered problems. However, there is a fine line between taking the necessary risks and ensuring that you have sufficient safeguards for when things go wrong.

As lawyers, we often see early-stage businesses get into difficulty by not having the basic legal documentation ready from the start. There is already enough unpredictability involved in launching a business, so founders should seek to minimise any ambiguity by implementing a written contingency plan in the form of a founders’ agreement. Effectively a pre-nuptial for your business, a founders’ agreement is a legal contract which regulates the co-founder relationship, providing specific rules to reinforce your business plan and some needed clarity in respect of the “what ifs?”. We often proactively protect our personal assets by signing a pre-nuptial agreement prior to entering into a marriage, so it would seem senseless not to do the same when embarking on a new business relationship.

Checks and balances

While there is no legal requirement to have a founders’ agreement, the practical benefits make them somewhat indispensable and invaluable for founders. Committing to a set of written terms helps preserve the best intentions of the founders and harness the spirit of the gentlemen’s agreement, but with the reinforcement of clear guidelines to rely on if there is a breakdown in communication. The agreement can ensure that each founder is fairly compensated for their efforts by clearly defining each founder’s role and obligations, thereby enabling founders to align their expectations in an open and transparent way. The agreement can also act as a useful roadmap for decision-making, as well as providing the necessary mechanisms to avoid any misunderstandings which may develop as the company scales. Having comprehensive dispute resolution procedures is especially important when starting a business with a friend or relative, where emotion is likely to cloud your professional judgment.

As such, introducing a solid constitutional framework not only provides a sense of security and stability for the founding team, but can also be instrumental when looking for investment. In addition to helping investors understand the company's structure, a well-drafted founders’ agreement suggests that the business is a serious contender, having proactively formed the necessary structure to properly deal with any adverse scenarios as they occur. Equally, not having a founders’ agreement can be seen as a red flag and may even deter investors from investing in light of the increased likelihood of disputes.

Will a shareholders’ agreement not suffice?

Although somewhat interchangeable, founders’ agreements are, however, usually a precursor to a shareholders’ agreement, namely a simpler agreement which only applies to founders, rather than all shareholders. Undeniably, there can be some overlap with founders often also being shareholders, but this may not always be the case. Some co-founders may hold options subject to vesting and will therefore not actually hold shares in the company until later down the line when they have perhaps met certain performance criteria or remained engaged for a fixed amount of time. Moreover, founders’ agreements are generally entered into earlier in the company’s life, with shareholders’ agreements normally being adopted on or following an investment round. Typical clauses found in shareholders’ agreements but not usually founders’ agreements can include share transfer restrictions; voting provisions; board matters; shareholder obligations for example, to maintain confidentiality and/or attend shareholders’ meetings; and material decisions reserved for approval by investors, to name a few.

The content of a founders’ agreement is not set in stone and the agreement is naturally a flexible document which should be specifically tailored to the business’s needs. It can be quite daunting to consider what should actually be included in your founders’ agreement, especially at the start of the journey when there are so many variables at play. However, some basic provisions which you would expect to be encapsulated would be the founders’ responsibilities (including any minimum active involvement threshold and remuneration, whether by way of salary and/or equity); intellectual property ownership and assignment if applicable; restrictive covenants and confidentiality clauses preventing founders from competing with the business and disclosing any trade secrets; what will happen to a founder’s shares upon incapacity, illness, death, termination or otherwise; and any dispute resolution and deadlock provisions for when unanimity cannot be achieved between the founders.

Certainty in the uncertainty

Of course even with meticulous planning, nobody can predict the future and account for all circumstances. Therefore the document must not be too detailed to preclude resolution in unexpected situations. There are no precise rules for creating founders’ agreements, but a balance must be struck between retaining the flexibility of the documentation and dealing with any loopholes as they surface. As a minimum, it is crucial to keep the agreement updated as the company evolves to reflect any new business plans or shareholdings and not to assume that anything is implicitly agreed without it being documented in writing to avoid potentially costly legal conflicts in the future.

Admittedly, there is no complete substitute for the value of goodwill and faith in your business partner, yet it is still best to install some certainty into the uncertainty of business by formally committing your business relationship to writing at the earliest possible stage. Despite any old fables, the most effective way of evidencing an enforceable arrangement remains by way of a written contract and founders should take steps towards dispelling the myth of the enforceability of gentlemen’s agreements once and for all.