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Man and woman seated at conference table, writing a formal founders' agreement

Reasons to Write a Formal Founders’ Agreement

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As a company scales, one of the most important things co-founders can do is formalize their relationship. Forbes lists failing to create a founders’ agreement among the top ten legal mistakes made by startups. Dozens of articles urge entrepreneurs to draft founders’ agreements as early as possible for their own protection. But approaching a founders’ agreement (FA) from that angle could establish the wrong dynamic. And having an agreement in place doesn’t safeguard your startup from founder conflict. Before establishing this important legal agreement, you need to take time to establish your co-founder relationship. You also need to understand the underlying principles and the mechanics of an agreement. Shikhar Ghosh sat down with Lara Hodgson and Sunil Nagaraj to discuss their vastly different experiences crafting formal founders’ agreements. Learn why all co-founders should write a formal founders’ agreement and what mistakes to avoid.

3 Reasons to Write a Formal Founders’ Agreement

  • Articulate and Align Expectations
  • Enhance Communication over Time
  • Establish a Process for  Future Decision-Making

For Hodgson, writing a formal founders’ agreement provided an essential foundation for the two startups she co-founded. Nagaraj had a slightly different experience. Writing a formal founders’ agreement for his first venture provided “some sense of stability on a legal basis,” he acknowledged. But, he cautions, focusing on the process of writing a formal agreement can lead to a false sense of security among partners. Learn why seasoned entrepreneurs believe that making time to think through the issues on a practical level and draft a flexible formal agreement is imperative to your startup’s success. Ready to write an agreement? See our Key Terms to Include in a Founders’ Agreement or check out the helpful tools at the end of this post.

Founders' Agreements Can Help You Articulate and Align Expectations

All teams begin with an implicit agreement and many co-founders assume that partners hold the same expectations. But an academic study of 10,000 founders, reveals that over 2/3 of founding teams decide on important issues at the outset of their partnership—without deep discussion. Most avoid conversations that could reveal misalignments about expectations of roles, rights, or equity—the core elements of a founders’ agreement. But taking time to align with your partner and write a formal founders’ agreement can help you mitigate conflicts. In the long run, it can save your business.

Writing a Formal Founders’ Agreement Allows You to Negotiate a Shared Vision

Entrepreneurs commonly associate founders’ agreements with protecting individual assets. And hundreds of articles and resources emphasize that the main function of a founders’ agreement is to allocate equity splits. But your founders’ agreement should do more. It should provide a roadmap that formalizes roles and responsibilities, stipulates right, and sets expectations. The agreement should reflect long and careful discussions about long-term expectations.

Drafting a founders’ agreement allows you to make sure that you and your partner have aligned expectations—before you write and sign a binding legal agreement. Lara Hodgson learned this when co-founding her second startup, NOW Corporation, a B2B payments company. One of her co-founders, Stacey Abrams, had become an elected official. Meeting regularly to discuss Abrams’ political aspirations and acknowledge that Abrams’ time with the startup would diminish as her political career evolved helped the co-founders agree upon expectations and mitigate future conflict. Hodgson recalls, “There were times when we would say, ‘she would be the best person to have this role.’ But we really can’t give her that role because we’d have to undo it in a year or two.”

The last thing you want is someone to have a mission-critical role and they start to fade off. Instead, think about, what role can we give her that’s important, but maybe a little bit ancillary? So, that as she phases out, it doesn’t cripple the organization.

Crafting an Agreement Doesn’t Guarantee Alignment

Like Hodgson, Sunil Nagaraj valued having a formal founders’ agreement as he believed the document would better equip him to handle uncertainty. Today a seasoned entrepreneur and investor, Nagaraj founded Ubiquity Ventures—a seed-stage venture capital firm—after several of his past investments, including Twitch, Defense.net, and Grow Mobile were acquired. While pursuing an MBA at HBS, Nagaraj co-founded Triangulate—a startup that developed profile matching platforms for social networks—with a close friend. The two labored to create a multi-page and comprehensive founders’ agreement that followed best practices.

Don’t Approach the Agreement as an Exercise—Thoughtful Reflection Matters

Nagaraj and his partner intently followed best practices and included all of the right terms. “We were fixated on process steps,” he shares, but neither truly wrestled with some of the deeper challenges. The process of writing the agreement “felt therapeutic.” He elaborates, the act of walking through “issues upfront made us feel like we were organized. In reality, we were going through the motions.”

Discussing potential scenarios—”What happens if a family member gets sick? What happens if you get hit by a car?”—made them feel prepared. But in retrospect, Nagaraj admits, focusing intently on the process left them with a false sense of security.

To walk through all those issues upfront made us feel like we were organized and more prepared for entrepreneurship. In reality, we were going through the motions.

He cautions others against getting caught up in the process and incorporating terms without truly thinking about long-term consequences. He encourages all co-founders to have deep discussions about expectations. Theses 3 Topics to Discuss before Writing a Founders’ Agreement can help.

Formal Agreements Can Enhance Communication over Time

Having some type of written agreement can enhance communication down the road. But timing is important. As Nagaraj discovered, writing a formal founders’ agreement too early might create a false sense of security or feel impossible to write because of the uncertainty that surrounds any early-stage venture. However, if you wait too long to start the process, you and your co-founders will form ideas and expectations. So when is the best time to create an agreement? How should you start?

Have Ongoing Conversations

Shikhar Ghosh, entrepreneur, investor and HBS professor who has advised hundreds of startups, cautions, don’t rush to create a legal document right away. Instead, have a series of conversations about your expectations and reactions to core issues with your co-founder. According to Wasserman, “If co-founders haven’t learned something surprising about each other from their early dialogue, they probably haven’t engaged in a serious enough discussion.”

Hodgson advocates setting aside regular time for ongoing discussions with your partners. When launching her first startup, Nourish, which produced formula-ready bottled water for infants, Hodgson and co-founder Stacey Abrams decided to forgo formal legal wording at the outset. Instead, they drafted documents with straightforward language that clearly delineated roles and expectations. The partners revisited their agreement periodically and made adjustments. Hodgson followed the same practice when she and Abrams co-founded NOW Corporation in 2010 and she believes that those ongoing conversations helped strengthen the partnership.

Write Down Your Expectations

Co-founders should have ongoing conversations. But it’s easier to gloss over differences during a talk than it is in writing. After a discussion, each founder should write a summary—in informal and simple terms—that captures both of your viewpoints—especially if founders conflict. Documenting your discussion allows you to highlight where you hold divergent views and negotiate opposing viewpoints. Then, draft a simple document that captures expectations. Meghdad Abbaszadegan, co-founder of FeelFree, had an irreconcilable split with his co-founder. Based on that experience, he recommends, “a simple one-page agreement that clearly indicates responsibilities while outlining company structure and operations can do a lot to ease tensions down the road.”

Plan to have ongoing conversations but document your expectations in writing, especially if areas exist where you and your co-founder disagree.

Don’t Get Caught Up in the General Process—Get Specific

Nagaraj recalls that “in the act of writing a founders’ agreement, what resonated with us was that we got to describe ourselves and talk about each of our skill sets” in broad terms. They focused on creating a viable plan that answered complicated questions about future commitments that may have been a great theoretical exercise. Unfortunately, while the document they drafted followed thorough guidelines, it didn’t address essential issues.

“We had very similar backgrounds,” he recalls, and largely overlapping skill sets. By focusing on the process of writing an agreement that contained the necessary terms, they failed, “to establish their expectations about who would do what, specifically.” For instance, they later learned, “both of us wanted to be CEO”—which couldn’t work. He underscores that it’s important that each founder state their expectations, in terms of titles, roles, and responsibilities. In turn, each person should thoughtfully review and comment on the other person’s expectations before writing a formal founders’ agreement.

We were more excited about the process than the result.  Now, with almost ten years of hindsight, the critical motions are figuring out what makes customers happy and figuring out how you’re going to build that.

Formalize Your Relationship  with Room to Iterate

Hodgson admits “I think the trickiest part about a partnership is that uncomfortable teenage phase of going from the informal to the formal and I’ve done it wrong in the past, to be honest.” She elaborates that, in the early stages of a venture, people can become attracted to the energy and offer to help informally. They may say, “I don’t need a title. I don’t need to be a partner” and they help out part-time.

As a resource-constrained founder, you accept the help. But as the business grows, Hodgson notes, “the person starts to want to be compensated or to be appreciated differently” which can generate friction. So formalizing your agreement earlier can greatly improve communication and make those uncomfortable situations easier to navigate.

Write one page that says, “Here’s my understanding of your role. Here’s my understanding of what you want to get out of this. We’ll reevaluate it in three months.”

Founders' Agreements Should Establish a Helpful Process for Future Decision-Making

A founders’ agreement articulates roles, responsibilities, and rights of founders, allowing you to negotiate a shared vision. More importantly, a formal agreement can establish processes that can help you resolve future contentious issues. Many founders don’t think about basic questions such as, “who will have the authority to make what decisions in the future?”

Ghosh notes that your founders’ agreement provides the opportunity to think about how you will handle future conflict. For instance, how will you handle deadlock? By what method will you reach consensus when making important decisions? In Hodgson’s experience, the sooner you can agree on future processes—and capture it in writing—the better.

A well-constructed agreement can defuse future confrontations by establishing an effective decision-making process. It builds in a mechanism for iteration, allowing for renegotiation when circumstances change.

Make It Meaningful

Nagaraj remembers that, for his first venture, writing a formal founders’ agreement made both co-founders feel they made “clear measurable progress towards something that is otherwise nebulous and scary.” But the agreement lacked real meaning to both. By rigidly following the right process steps and best practices, they failed to address their real expectations and dig into the context of their situation. The founders’ agreement Nagaraj co-create for his first venture provides one tangible value: it “introduced the notion of vesting. It tied us together and introduced some sense of stability on a legal basis.”

Otherwise, the agreement functioned as an intellectual exercise. In retrospect, he assesses, “That founders’ agreement in retrospect was worthless.” Going through those motions proved “somewhat helpful, but not critical.” He encourages others to think about critical elements when writing a founders’ agreement. Primarily, figure out what makes customers happy, and draft a roadmap for how your startup can build that product or create that service. That means you need to specify the role each co-founder will play.

Figure out what makes customers happy. Figure out how you’re going to build that. That’s that we should have been doing. We fixated on process steps. That founders’ agreement, in retrospect, was worthless.

Make It Dynamic

Hodgson notes, “founders’ relationships with each other change over time.” Initially, you might feel swept away in the excitement of co-creating. When “things start to hit that first plateau,” she observes, and you have to make tough decisions about streamlining, or cutting costs, or even pivoting, emotions often run high. Having a written document to refer to that states, “this is how we will decide X issue” can defuse tension and help guide you through conflict in a more productive fashion.

She cautions, “if you too soon try to get too complex in your formality, it won’t grow with you.” On the other hand, staying informal too long often leads to hurt feelings, “then people start to get into arguments that probably should’ve been had sooner.” But revisiting your agreement regularly can strengthen your partnership.

I view it as an iterative approach. Start somewhat informal—get a simple agreement in place. But revisit it every three months. Each time you revisit it, it may become a little more complex because things become a little more formalized.

Is  Writing a Formal Founders’ Agreement Worthwhile?

You can’t predict all future circumstances with accuracy. And in Nagaraj’s experience investing too much time trying to create a perfect founder’s agreement can backfire. Despite his experience, he agrees with Hodgson that a well-crafted agreement can provide a mechanism for dealing with future conflict. But you all parties must take time to honestly assess their aspirations and candidly share expectations.

At a minimum, your agreement should address roles, responsibilities, projected time commitment, and equity. The best agreements don’t establish terms that last in perpetuity. Instead, write your founders’ agreement as an iterative document and allows you the agreement to adjust as circumstances change. Both Hodgson and Nagaraj stress the importance of taking ample time to write the agreement. Listen to your partner. Then, working together, create a fluid document that you should revisit and change periodically. Want advice on what specific terms to include in your agreement? See our Key Terms to Include in a Founders’ Agreement or check out the helpful tools below.

  • Having a written document to refer to that states, “this is how we will decide X issue” can defuse tension. It can help guide you through conflict in a more product
  • Your founders’ agreement should  incorporate a way to iterate over time. Resist the urge to get too complex in your formality too soon.

Explore More

We reviewed major resources and articles and talked with experts about founders' agreements. We recommend the following content.

Resources

  • The 3 Essential Things Needed in a Founders’ Agreement” by Bo Yaghmaie, Head of New York Business & Finance Group, Cooley LLP, explores 3 core issues that a founders’ agreement should cover: roles and responsibilities, equity, and IP ownership.
  • In “How To Create the Perfect Co-Founder Agreement With Your Business Partner,” the Founder Institute outlines topics that co-founders should address before launching a venture.
  • How To Draft An Iron-Clad Founders’ Agreement” by Jiah Kim provides founders’ agreement ideas that will help your startup grow, and avoid common founder-related issues.
  • In “The Secret to the Successful and Lasting Co-Founder Relationships,” Steli Efti, co-founder and CEO of close.io, shares how he and his co-founders weathered extreme highs and lows and emerged stronger.
  • Noam Wasserman’s book, The Founder’s Dilemmas: Anticipating and Avoiding the Pitfalls That Can Sink a Startup, is based on a decade of studying tens of thousands of startups. He examines the common mistakes founders make and suggests ways to avoid them. Issues he delves into include: is it a good idea to co-found with friends or relatives? How and when should you split co-founder equity? How can you recognize when a successful founder-CEO should exit or be fired?. Learn “how to anticipate, avoid, or recover from disastrous mistakes that can splinter a founding team, strip founders of control, and leave founders without a financial payoff for their hard work and innovative ideas.”
  • Why You Need Founders’ Agreement?” by Bittu Kumar, co-founder of Enterslice, a Company that helps entrepreneurs start and manage their ventures in India provides several rationales for creating a founders’ agreement, including, making it easier to decide how to share proceeds generated if the company dissolves.
  • In “10 Big Legal Mistakes Made By Startups,” attorneys Richard Harroch and Richard N. Frasch list “not making the deal clear with co-founders” as the top legal mistake made by entrepreneurs. The piece reviews other common mistakes such as not incorporating or protecting IP.

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