Four Legal Documents for Co-Founders
The following post about Four Co-founder documents is taken from an interview with Joe Wallin – Startup Law Blog .
Parker: Hi, this is Dave Parker and I have on the phone with me Joe Wallin from Davis Wright Tremaine. Joe, thanks for joining me.
Wallin: Great to be here.
Parker: Joe’s been with us before. He’s an attorney for Davis Wright Tremaine, a law firm in downtown Seattle and various other places around the country and the world, and Joe works with early stage firms to help them with incorporation and then of course on the deal side too, on exit.
Last time we talked about early stage docs and formation and this time, Joe, I wanted to talk with you about cofounder documents and particularly what cofounders should be thinking about as they enter into their new startup with cofounders.
Parker: Specifically the docs we’re talking about today are the IP Assignment Agreement and components. Second is a Voting Agreement. Third is a Vesting Schedule and finally a Buy-Sell Agreement and when these docs apply. So, with that let’s just kick it off and go right to what people should know about the IP Agreement and what are the general components of those things.
Wallin: Sure. An IP Assignment Agreement is what it sounds like. It’s an assignment of all the intellectual property associated with a project to the new company and this is, obviously, something investors want to see before investing because they want to know that the company owns the intellectual property. Co-founders should also care about this because if you and two other people found a company and one person quits and leaves to do something else, the last thing the other two co-founders want is this loose end where the one co-founder who left never assigned the IP to the company now has a potential claim against the company for its intellectual property.
Think of it this way. If you don’t get an IP assignment from your co-founders, you are doing the equivalent of giving them a knife that they can cut you with later.
Parker: So when co-founders or when founders and new startups think about assignment of IP, what is included in an IP assignment, what do they need to know about it?
Wallin: Well, it is typically an assignment of all of the intellectual property that the founder has–the code, the trade secrets, all the ideas and innovations associated with the project. You typically see very broad based assignments. You can find any number of examples of these documents on the Internet but they are typically all-encompassing assignments of all intellectual property, patents, patent rights, trade secrets, mask rights, anything you can imagine that falls within the definition of intellectual property will be assigned.
Parker: So that would include things like domain names, and if there are multiple versions of domain names, and well but I paid for that even though you paid for it, the fact is with an assignment agreement you’re assigning it now to that company. Not some individuals, right?
Wallin: So domain names are a good example because you’ll want those to be held by the company and the company will actually want to have – if founders bought a domain name in the founders own name, maybe under a founder’s own godaddy account or other account and never took the time to transfer it to the company’s account, that’s a situation where things could go poorly if that co-founder leaves, maybe leaves unhappily and then refuses to cooperate in the transfer of the domain name, even if they have a good legal document signed in which the founder assigned the name, the brand name, the domain name, and everything else. If the company doesn’t actually control the account under which it’s held and the founder who does refuses to cooperate that can be bad.
Parker: I’ve seen that happen at a Startup Weekend before where people have an idea, everybody kind of throws in their effort behind it, and I’ve seen two things happen. One is there is no discussion of assignment agreements and there have been the VC who brings their idea and has everybody sign an assignment agreement in advance – and people are offended by it.
Wallin: That’s exactly right. What’s hard about these situations is if you don’t tie up all the loose ends and make sure all the IP is held within the company, essentially what you are doing is you are setting up a situation where downstream someone can make a claim against the company and demand payment or compensation or additional compensation. You want to try to avoid that type of situation. You want to set the company so that there are no future claims that can come up because everything has been defined at the outset. Everyone receives founders’ shares in exchange for their assignment and there’s no lingering risks associated with future claims.
Parker: So, also part of that release and IP assignment, there is typically stuff about non-compete and non-solicitation, so what is the language in there that founders should be aware of?
Wallin: It’s not uncommon in the State of Washington to put in the founding documents some sort of non-competition agreement so the idea would be — in the IP assignment agreement or the founders stock purchase agreement — to have a post-service non-competition agreement. So it would say, for one year or for 18 months or for some period of time after you are no longer providing services to the company, you won’t compete with the company in the business in which the company is engaged. That’s not an uncommon thing to do in the State of Washington and then it’s also not uncommon to include a non-solicitation clause, which is a prohibition on trying to hire people away from the company. That provision would say that the founder agrees that during the period of time that they work for the company and for one year or two years after they ceased working for the company they won’t try to hire away anyone who is providing services to the company to a different company.
Parker: Great, so I know one of the things that people, at least the first-time co-founders or founders, are kind of confused about is there’s this perception of hey, it’s my idea and the fact is that this is your idea until such time as you incorporate and then those ideas become owned by the entity, at least if you ever expect to raise outside capital.
Wallin: Right, the company is going to want to own the idea and own all the intellectual property associated with the execution and implementation of the idea. That’s what the company is going to want and that’s what co-founders are going to want and that’s what future investors are going to want.
Parker: Let’s talk about the second document, the Voting Agreement,. What are the concepts and the details surrounding the voting agreement.
Wallin: Sure, well what I explain to founders is that if you don’t have any written documents in place regarding voting of shares then the way it works is holders of the majority of the voting shares can replace the Board of Directors of the company at any time. So Dave, if you and I started a company and I owned 60% of the voting stock and you owned 40% of the voting stock because that was our agreed upon split, at any time I could decide, gee, Dave, I’m not really very happy with your services. I’m going to let you go. And I could let you go. And so that example I gave of the 60-40 split is sort of your classic example of a dominant founder and the subordinate founder and there are plenty of great examples of those stock split situations working just fine. If I recall correctly, I think Bill Gates and Paul Allen were 60-40 and obviously they had a successful relationship and built one of the world’s great companies so it didn’t hold them back. Say you were concerned that I might decide to throw you out of the company in a year’s time or something and you wanted to be sure that you had a seat on the Board so that at least you had visibility on the inside as to that decision-making process, we could sign a voting agreement where I agreed to vote all my shares to elect you to the Board and you agreed to vote all your shares to vote me to the Board and we agreed that the Board could be comprised of at least the two of us and additional people as we agreed to from time to time. These situations become difficult because even that doesn’t prevent you from being terminated as an employee if we appointed a third person to the Board and that third person and me decided that you were not working out. We could let you go. But it’s something the founders might want to think about when they’re putting together a company.
Parker: That kind of falls into one of those general rules of thumb. Much of the legal docs are designed for when things don’t work out right or smoothly.
Wallin: Right, to flip the example, if you’re the 60% founder, you may prefer not to have any kind of voting agreement in place. You might want to have the right to control the Board and let me go – the 40% guy if I’m not working out. That might be what you want.
Parker: So it’s a good heads-up to have the discussion about what happens if this doesn’t work out well, right? Because that euphoric stage of a startup, we think everything is going to be awesome.
Wallin: Yeah, that’s right. It is hard at the outset sometimes to think about and focus on planning for things not working out.
Parker: So next up is the vesting agreement. What’s the components of a vesting agreement and what should founders know about that?
Wallin: Well, so the idea here is that we’re going to be 60-40 founders and – but if one of us doesn’t continue to work on the project, for their expected time period, the shares – whoever quits early will not be able to keep their shares so and let’s just suppose it’s 60-40 and I’m the 40 and you’re the 60 and I work for a few months on this thing and then I decide I don’t really want to work on this anymore, so I leave. You won’t be happy if you find out that I get to keep my 40% even though I only put in a few months of work. You would like it to say that I’m going to vest in my shares over some period of time so a typical example would be I would have to work for four years to be fully vested and keep my 40%. And I would have to work for at least a year to vest on my first 25% and then maybe after first 25% is vested, every month I am vested an additional amount. And so the idea is, we’re going to impose some vesting conditions on our shares because really implicit in our deal is we’re each going to work on this for some period of time. We’re each going to plug away on this for some period of time and if we don’t, then we’re not going to be entitled to keep the shares we were issued.
Parker: Well, I think you bring up a great point. It is implicit but sometimes not stated for founders and co-founders have the discussion of, hey I’m a contributor – I’m going to come to the company with 40% but I’m going to work full time and you’re going to work part-time and you have 60% and then it causes that friction between us as co-founders. Or, worse yet, I come in and I’m working full-time at 40% and you’re working full-time and then you’re putting cash into the deal as well so all of those different scenarios are things that everybody has expectation whether they communicate them or not?
Wallin: Yeah, and I think you’ve got to have a discussion like, how much time we’re each going to put in, how much time are we going to commit to both in terms of monthly time commitment or weekly time commitments. How much time are we going to commit to and for how many years or months are we going to commit to that. Usually when people start a company and they agree to split the shares 60/40, if they don’t talk about it, what they really mean and intend is that each party is going to work for some period of time. They don’t mean that if somebody walks off the job in two weeks they get to keep their 60 or 40. So it’s important to document what’s meant because if it’s not documented then someone can walk off a job and then they get to keep that, like I would get to keep that 40% if two weeks later I quit. And that would not be a good situation for you. You wouldn’t be happy if I, two weeks later, quit and I still own 40% of the company and you had no way to get it back from me.
Parker: So, with a vesting agreement it’s really about how the shares vest. But one of the things we are talking about here with having this discussion and documenting as well was the work expectation is, what the time commitment expectation is in percent of hours per week, fulltime, part time and even what the duration is, which I know is that one’s really hard for founders when they are starting. It’s like, “I’m going to work for the rest of my life and you’re like I’m going to work for like three months and we get traction great and if we don’t get traction I’m out of here”. So having those discussions are really important to them as well.
Wallin: You’ve got to have those discussions to be open and frank about it. Or at least try to be. The sooner the better.
Parker: So let’s talk about the last document, the buy sell agreement. So one of these, in many cases, this is not one of those people think about or talk about in advance and it does have a lot to do with expectations. So what are the components of a buy sell agreement, how would you structure a buy sell agreement and what does it look like from a founder/co-founder perspective?
Wallin: Sure. What we’re talking about with the buy-sell agreement is: can one founder buy out another founder under some set of circumstances? So in the circumstances we were just talking about in our example if it was 60/40 under what circumstances, aside from the fact that let’s suppose we both agree that we’re each going to work full time on this thing for two years before we fully vest. We each work for two years full time on this until we’re both fully vested. What happens if we come to an impasse at the two and one-half year mark about the direction of the company. Do we want to have an agreement in place which gives one party the right to buy out the other party in that event? Or what happens if you become unable to continue to work in the business? Does the company want the right to buy your shares back at fair market value if you are no longer working in the business or if you become disabled or if you die. What happens if you die? Does the company have the right or does the other side have the right to buy your shares back if you die? It’s pretty typical in vesting or in common stock founders, common stock purchase agreements or vesting agreements–it’s pretty typical for the company to retain the right to buy the shares back from a founder for fair market value if they cease providing services to the company. So upon the termination of the service relationship vested shares can be repurchased at fair market value. I would say it’s less typical for the founders to enter into cross purchase agreements where, for example, I’d have the right to buy your shares back or you’d have the right to buy my shares back. That’s less typical but it does happen. But more commonly it’s the company having the right to buy back shares at fair market value upon termination of the service relationship.
Parker: So let’s work through a scenario just as an example. So there’s a couple of intuitive examples. So, we’re in a two year vesting schedule, at the end of year one I say Joe, circumstances have changed. Life happens. I’m leaving. I’m the 40% and you’re the 60%. If we have a two year vesting schedule I have vested half of that 40% so I have 20% vested and 20% unvested. What happens in that scenario?
Wallin: In that scenario the legal documents would provide that the unvested shares be repurchased at the lower fair market value or cost so the 20% you’re not vested in the company is repurchased from you either at the price you paid or if the fair market value of them is less than the lower price, the fair market value price, so your unvested shares would go back to the company. And then with regard to your vested shares, it is very commonly the case that the company has the right to buy back the vested shares at the fair market value if it chooses to do so, at that time the company would either chose or not chose to do so. If the idea is, hey, only people who are in the boat pulling the oars should benefit from the increase in value then the company will want to buy back the shares at fair market value when you quit and you would have gotten the benefit of the increase in value from the start date to your quit date but you would then no longer be a stockholder at all and wouldn’t benefit from any appreciation in the company from that point forth.
Parker: Great. So the one there that seems to be pretty obvious from a founder perspective is the unvested shares you get to buy back for perhaps a buck, right? So, because we need to put those back, at the very least put those back into the pool made available for other potential co founders or key hires to fill the role that I just vacated. So that one makes tons of sense.
Parker: And then you kind of have an either/or, right? If we agreed on a buyback in advance then it would be, hey Dave, we’re going to buy the 20% of your shares back at the fair market value or if we’ve said if we don’t have a buy sell agreement in place it basically says I get to keep those shares until such time as they have some form of liquidity if there is no buy back in place. Is that a safe assumption?
Wallin: Sometimes it’s the case that agreements, founder agreements, don’t provide the company the right to buy back vested shares at fair market value. Sometimes the agreements only provide the right to buy back the unvested shares so, in the case you gave, the example you gave, if you were 20% vested and 20% unvested in that circumstance only the unvested shares could be repurchased and the vested shares you continue to own them forever. You’d be subject to dilution as shares are issued in the future and it’s also possible that you would come to an agreement to sell your shares but you couldn’t be forced to. So these are important things to think about when you put the company together. Do you want the company to have the right to buy back vested shares at fair market value? Or do you want to just be silent on that?
Parker: So it is an important conversation for founders to have in advance which is you need to understand that part of the reason we have a vesting schedule, even though we’re both founders and even though this is our equity, you “must be present to win” to continue to get those shares. You don’t get 40% for three weeks and then you leave.
Wallin: I recommend that a company always retain a fair market value repurchase right from a founder who quits. That’s what I recommend because that’s what is in the best interest of the company, to at least have the option to buy back shares from a founder who has quit.
Parker: Great. Well Joe, thanks for the time and thanks for covering these co-founder documents. I appreciate it and we’ll look forward to chatting with you again.
Wallin: For sure. Thank you Dave.