Being a founder, not to mention a CEO, can be a very lonely place, carrying loads of stress and required to constantly be at peak performance. This often makes it hard to find a balance between one's professional and personal life. Maintaining strong relationships with the co-founders and investors is also not an easy task, where clarity and empathy are not always present. As one of my entrepreneurs says: “It’s not the technological challenge we deal with, it’s the mental one.”
“Throughout my +15 years as a professional, I've always been attracted to the intersection of business and psychology through entrepreneurship - What makes people tick? How do people think and act? And what motivates people in business? What drives me is being there for the amazing entrepreneurs, who are under constant pressure, so that they can make our world a better place. That’s what I’m here for, and this is my podcast – The Human Founder.”
With Adv. Guy Lachmann, Senior Partner, Pearl Cohen Law Firm
This series will discuss the psychological aspects that are intertwined with the legal aspects of the entrepreneurial journey - and most importantly - the founders' agreement, choosing a lawyer, and the case of separation between partners.
I'll open on a personal note – I pursued my bachelor's degree in Law and Psychology. I didn't know what to choose, but I knew I was drawn to both. I did my apprenticeship at Herzog Fox & Neeman, in their Private Clients department - a department that represents all the wealthy people we read about in the paper and whose psychological motives are the basis for all their legal conduct in financial agreements, trusts, wills, assets allocation and more. After I graduated, I decided to leave the profession, but a lot of the principles I learned remained with me and still guide me today.
As an executive coach and advisor who works with startups, entrepreneurs, and investors, I once again became aware of how ingrained psychology is in all commercial and legal agreements. Today, I understand why I studied the two degrees together, and how they exist in perfect symbiosis within my daily work. Even though I don’t function as a lawyer or a psychologist I can bring my perception of the two worlds to the table.
In my conversation with Lawyer Guy Lachmann, a friend and colleague, who specializes in working with founders and startups, we focused on the mental and psychological aspects inherent in the legality of the entrepreneurial journey–especially the founders' agreement, in choosing the right attorney for you, and what happens when people decide to part ways. An attorney is one of the closest and most important advisors to an entrepreneur, and he shouldn’t just be knowledgeable about the law– he should also be a person who really sees you, your values, your style and helps you advance your goal.
Disclaimer (I am after all still an ex-attorney) - this series will provide knowledge that will help you shed light on the field but reflects our perspective and worldview and is not a substitute for legal advice. Guy and I recommend you consult a lawyer if the topics of the podcast are relevant to you before taking any action. Each case should be examined on its own merits and its individual aspects weighed. The conversation is meant to give you a general impression from the opinion of the speakers only.
The Founders’ Agreement
The founders' agreement is the contract signed by the entrepreneurs when they start. This is one of the most critical and impactful agreements for the venture and could shape its future.
The purpose of the agreement is to arrange things between the founders and is an indication of their maturity, seriousness, and decisions to formalize their relationship.
Companies that started with a proper founding agreement have survival was greater. There is an affinity between the writing of the agreement and the chances of success.
And yet - many entrepreneurs refrain from doing so. Why is that?
1. There is a general reluctance for entrepreneurs to engage in legal issues.
2. There is ignorance and naivety in legal matters and the legal consequences.
3. It isn’t prioritized - entrepreneurs prefer to deal with other aspects that the venture requires.
4. Some entrepreneurs don’t want to sign the agreement, which can indicate a general lack of seriousness and a desire not to be in a binding legal relationship.
All these barriers cause reluctance, avoidance and/or procrastination - behaviours whose results usually don’t benefit us or the startup's progress.
Also, downloading templates of founders’ agreements from the Internet is not recommended. There’s a difference between American and Israeli law, for example, and American templates don’t fit the Israeli legality in matters of IP, taxes, and general terminology. There are templates for everything in every field - but the issues are so sensitive and specific to you that they should be done by a skilled professional.
There are many similarities between entering into a relationship with a co-founder and embarking on a shared path as a couple in private life, in which a financial agreement is signed to regulate the division of assets, hedge risks and define the relationship in a healthy way. The personal and psychological situation is similar - since in both cases you are going to spend a lot of time together, giving it your soul and all, you got - these are relationships that are life-changing. Therefore, one can look at the founders’ agreement like a prenuptial agreement. The purpose of these agreements is not only to define what happens when the relationship hits a wall or a rainy day but also when things are good and going as planned, by creating an unambiguous, clear, and understandable framework.
When is it the right time to sign a founders’ agreement?
When romance is at its peak - a second before starting a company or close to starting a company. Why? Mainly because of taxation, there are mechanisms involved in the transfer of shares - and the further you wait with signing the agreement from the date of establishment of the company - the more problems it can create. It’s important to take the creation of the company at the right time very seriously - and this also relates to the issue of intent I mentioned above - how much the entrepreneurs are committed to communicating and willing to take the endeavour seriously and wholeheartedly.
"There are only two things certain in this world: taxes and death," said Benjamin Franklin.
Taxes can negatively impact companies and deals, so it’s very important to give them the right attention. Waiting with the establishment of the company can generate a "tax event" - a liability to pay taxes - in the context of the transfer of intellectual property from the founders to the company. Intellectual property is equivalent to an asset– a piece of property, a share. The transfer of property is the same as its sale and should be paid for at the time of the establishment of the company–the allocation of shares has a price determined in accordance with the value of the company and the income and expenditure of assets–all of which is a taxable event. There are different approaches to managing this matter - but as an attorney - you should be careful and advise entrepreneurs from the perspective that will protect them.
The founders' agreement is not meant to live forever - it has an expiration date, and usually as soon as a significant investor enters - the founders' agreement "tends to die" and other agreements will be made - for example, the company's bylaws. When the balance in the company changes - so does the agreement. At the same time - to bring in serious investors and more due diligence - it’s important to have an orderly founders’ agreement that defines the roles, IP, and other important things.
What does the founders' agreement include?
1. Proper distribution of equity
"Ventures can explode on the distribution of equity, for example, in cases where entrepreneurs distributed 48-52% because of 'seniority' on the idea." It’s very important to give the feeling that the entrepreneurs are being rewarded properly. One should be alert to a problematic holding structure that can be created because of an incorrect capital dispute. The right environment needs to be created for everyone to be involved. If there’s a feeling of "I have more", it can lead to suppressing the other founder and then the company will collapse. And if that happens - then it should be before the company stands on its feet and raises money.
It's so important to really see each other, build balance and be strong together.
One should pay attention to cases wherein terms of decision making - two outweigh one - because it’s unhealthy to go to bed at night with the thought of a majority that might oust me.
One should always think about how to build structures that create balance, and what decisions require the consensus of everyone - and not just the majority. Things that are part of our worldview - for example - the sale of the company, a fundamental strategic change, etc. As a general statement - the right way to follow is to be smart, not right.
When you bring in a partner to the company at a late stage - there’s a "potential accident" at the door; if we have already established a company and only after a year a new partner joins - there is complexity, and we need to create a creative mechanism that will suit the joining of the new founder with the existing one. There is no unequivocal solution to the situation because on the one hand there’s already value to the company / technological asset - and that has tax value. On the other hand - you want to give the right compensation, which will be reflected in the amount of equity he'll receive. There is an inherent tension between the pressure of starting a company and finding a good partner and financial value - and that’s a set of stressors that need to be recognized and cannot be ignored. This is basically a psychological question that involves looking at the people involved, examining the contribution that has already been made and what resources have been invested.
The classic vesting idea: we’ll create an equation that is influenced by the time – the more we dedicate, the larger the share capital we will receive. There’s a correlation between contribution and time. The classic mechanism is 4 years for employees and consultants.
For founders - a reverse vesting mechanism is manufactured - the founders' shares will be linked to their continued functioning and involvement in the company. If they leave within a predetermined period, they must return some of their shares. It's basically a kind of "sword" over their head - that if they leave - some will be taken, but what they have invested so far - is theirs. The Cliff and the Vesting are critical mechanisms for the survival of the venture, and their proper wording also constitutes a good signal to investors.
The essence of these mechanisms anchors within it the psychological elements of commitment, seriousness, desire, resilience, perseverance, direction, relinquishment, risk management, belief, and the choice to base the risk on us over time - and all management of negotiation over the options - anchors within them these elements.
2. Proper definition of the roles
It’s not enough to just assume a title - it’s worth trying and describing the roles in a defined and detailed way. Any change in the job definitions must be written in the founders' agreement, which, as stated, is a dynamic document. Sometimes the role definitions themselves are embarrassing - but it’s very important because this is what enables the management of domains, effective work, and the prevention of situations in which one steps on the other's toes.
3. Establishing a decision-making mechanism
This is a wide, complex issue; there are many opinions and many ways to settle it. But there are some important anchors - for example, defining the decisions that require a consensus. For example, closing the company/ bringing in an external investment that requires dilution and/or sale - it is better that such decisions are made together and agreed upon collectively. In addition, it is possible to produce a list of topics in which there should be a special majority of the founders - regardless of the size of the holdings in the company. The DNA of the entrepreneurs and the connection with the partners are so important and producing these agreements is just as important.
And what happens when the doctrine collapses and there are 2 founders that hold equal shares (50-50), yet they fail to reach an agreement and enter a deadlock? Often, through extreme pressures and changes - someone eventually nudges and comes around. But sometimes others take a spiteful approach and are not willing to let go.
4. Intellectual Property - you need to produce a series of this domain and make an orderly transfer of the IP from the founders to the company.
5. Make sure that there are no third parties with claims to the company/idea - for example, previous employers and/or within academia.
6. Financial management - a precise definition of who makes decisions regarding money and in what way.
There must be a dynamic coordination of expectations between the entrepreneurs. For example - if an entrepreneur takes a "day job" in addition or wants to go on a significant vacation of a few months - this will affect the conduct of the joint venture. Therefore, a "framework of consent" should be established - so that all the important things - will be agreed upon in advance.
So do you need to go to an attorney to sign the founders’ agreement? - as we said - you shouldn’t do it alone at home. The agreement should be signed after all the commercial agreements have been formulated and everything is properly established.