Mind Your Business: Part Three – Agreements Among Founders and the Entity

There is a nearly infinite number of agreements founders can make amongst themselves and with the business. A few of the most common types are discussed below. Keep in mind that some agreements will not be valid if they contradict a statute that governs the operation of your particular entity type. This article does not take consideration of such statutes. As always, before drafting any agreements that will impact your business, you should consult with a knowledgeable attorney to discuss your goals and the best way to reach them.

Founders’ Agreement

A Founders’ Agreement is a great starting point when you first meet with your fellow founders to get in writing the things you expect from your business. It can also help to solidify your common goals and see the path of least resistance to get there.

The Founder’s Agreement will often include the roles and responsibilities of each founder, the method for decision-making and operation of the business, ownership interest, how contributions will be valued, vesting of interest, and how to handle the voluntary (or involuntary) departure of a founder.

It is important to keep in mind that the Founders’ Agreement is just a roadmap for the business and to be sure all appropriate topics are included in the operating documents of the entity.

Stock Control Arrangements

In some situations it is necessary to give a member or shareholder more voting power than their membership or share ownership percentage would otherwise allow. There are a number of mechanisms by which to accomplish this.

            Supermajority Voting Requirement

In a privately or closely held company, a minority shareholder may require a veto over certain major corporate decisions or actions as a condition of that minority shareholder’s investment. Such a requirement can be included in the articles of incorporation and bylaws.

            Irrevocable Proxies

A proxy gives the holder the right to vote the shares covered by the proxy on matters specified in the proxy. A proxy can be made irrevocable under specified circumstances.

            Voting Trusts

In a voting trust, shares are placed under the control of a trustee who votes the shares as provided in the voting trust agreement. In many states, including California, the length of the term of a voting trust is limited, subject to certain rights to extend the term.

            Dual Classes of Stock

One class of stock can be given substantially greater voting power than any other.

            Cumulative Voting

An agreement can be made in connection with representation on the board of directors through cumulative voting, which allocates each shareholder a number of votes equal to the number of shares times the number of directors to be elected. In California, unlike in Delaware and most other states, cumulative voting is mandated in the case of certain publicly traded, exchange-listed companies.

Buy-Sell Agreements

Buy-Sell Agreements protect the rights of the remaining founders when one founder dies or leaves the company.

This is best illustrated by example. Chris, David, and Matt found DW, Inc. Sadly, Chris passes away, leaving his shares in DW, Inc. to his wife, Rose. Rose then has one-third ownership of DW, Inc. and (in this scenario) the right to elect herself to the board of directors. However, Rose has a different idea of how she wants DW, Inc. to be run and David and Matt don’t want her to have control. If DW, Inc. has a Buy-Sell Agreement, his estate (here, Rose) is obligated to sell Chris’ shares to DW, Inc.

What happens if DW, Inc. anticipates it will not have enough money to purchase the shares from a deceased founder or doesn’t want to spend its money to do so? DW, Inc. should have an Insured Buy-Sell Agreement where either DW, Inc. or each shareholder, buys insurance on the founders to cover the obligation on the company to buy those shares.

Buy-Sell Agreements often include a right of first refusal. A right of first refusal says that if a shareholder wants to sell his shares to a third party, he has to offer them back to the company and if the company passes, they are offered to the shareholders. The Buy-Sell Agreement will often include a provision that says the price offered to the company and then the shareholders is the lower of either the offer price to the third party or the formula basis set forth in the Buy-Sell Agreement. So, if Peter offers Matt $1MM for his shares in DW, Inc. and the formula in the Buy-Sell Agreement values Matt’s shares at $1.5MM, Matt must offer the shares to the company, and then the shareholders, at a price of $1MM.

Purchase can also be triggered on a “triggering event” such as upon a founder leaving the company or on being fired. Sometimes Buy-Sell Agreements will also provide that if one of the founders becomes divorced, the shares, instead of being divided as community property by a court, must be reoffered to the company.

Transfer of Founders’ Technology to the Entity

There are two basic types of agreement that will transfer the technology of a founder to the entity – an Inventor’s Licensing Agreement and an Inventor’s Assignment Agreement.

            Inventor’s Licensing Agreement

In a licensing agreement, the founder/inventor retains ownership of her intellectual property, patents, and trade secrets, but licenses them to the entity in exchange for shares and possible a royalty fee.

For example, if Kaylee licenses the engine she designed to Serenity, Inc. in exchange for shares and a royalty fee, the engine and the associated intellectual property remain hers even after she leaves the company. Serenity, Inc. is merely “borrowing” the information.

            Inventor’s Assignment Agreement

In an assignment agreement, the founder/inventor makes a full transfer of all right, title, and interest in the technology or intellectual property to the company in exchange for shares.

Here, if Kaylee were to assign the engine she designed and all associated intellectual property to Serenity, Inc., she would receive shares in the company, but would not be entitled to royalties or any future interest in that technology.

            Employment Agreements

Employment agreements are used by companies to protect the rights of the employees as well as protect the trade secrets of the business. Employment agreements often include specifics as to the term of employment, benefits, rights to technology of the employee (as discussed above), termination events and compensation payable on termination, and how to resolve disputes. Many employers want to include a covenant not to compete, but in California these will generally not be enforceable, except in connection with the sale of a business.

Conclusion

There are endless variations of agreements among founders and with the company, which is why it is important to consult an attorney regarding what you are seeking to do to find the most efficient means to accomplish your goals.

By Jessica Coffield