Say an entrepreneur has started a company — she has moved from being an employee to embracing the title of founder. She and others now own this company and intend to build it out. She and her co-owners have shared commitments and goals. In her past life as an employee, she may have signed an employment agreement. But are employment or shareholder agreements essential tools for a startup founder? The answer is no — such documents are not necessary for an early-stage company, and may even hinder the ability of the company to attract investors and obtain financing.
A shareholder agreement identifies initial shareholders and defines each person’s roles and responsibilities. It may specify how equity can be transferred, it regulates the use of intellectual property belonging to the founders, and it imposes structure to formalize the shared commitment of the founders to the new venture. But in a closely held corporation with a limited number of owners, the agreement may be unnecessary and cost-prohibitive. The laws of the state in which a company is incorporated generally provide rules for the formation, ownership, and governance of a corporation, and these rules offer a sufficient structure for a company in its initial startup phase.
Employment agreements also present drawbacks for startups. While such agreements often provide for the retention, compensation, and buyout of employees, they are inherently unattractive to potential investors, who fear the company may be limited by existing contractual obligations. Investors prefer that the company have “at will” employees who can be freely terminated, so that cash can be used to build a business rather than pay off its founders.
So what documents are a good idea for startup founders to have? These include any documents outlining (1) the roles and responsibilities of the founders, (2) equity distribution and vesting (in case any founders leave or are replaced); and (3) how intellectual property rights are shared. Specifically, startup founders should have the following documents in place:
This standard document, which is approved in connection with the incorporation of the company, governs the conduct of the company and sets forth the rights and powers of its stockholders, directors, and officers. It provides for a general overview of how the company operates and governs, and outlines the roles of its stockholders, directors, and officers. It also includes indemnification provisions, to reimburse any director or officer for expenses incurred in the course of litigation.
(2) Restricted Stock Purchase Agreement
This document provides for the issuance and sale of stock to the founders and sets forth initial provisions providing for a forfeiture of any unvested shares in the event a founder leaves the company prior to a specified date. Each founder signs their own restricted stock purchase agreement. Standard vesting is four years with a one-year cliff, and often includes acceleration provisions in the event of a change of control and involuntary termination thereafter. For more information on the benefits of vesting schedules and types of provisions, see Why Is Vesting Important for Founders? and 5 Important Considerations for Founder Vesting Schedules. For more information about vesting acceleration, see What Does Acceleration of Vesting Mean?
(3) 83(b) Election Form
This document gives a founder (or employee) the opportunity to pay taxes on the total fair market value of stock at the time of grant, as opposed to the time it vests. The purpose of this document is to allow founders to pre-pay their tax liability, assuming they expect the equity value of the stock to increase as the shares vest. This document can save founders significant amounts of money if the company does well but also carries risk: founders could pay taxes on earnings that never materialize if the company has a down round. The 83(b) election must be sent to the IRS within 30 days of the issuance of the shares Founders. Founders are advised to consult with their individual tax advisers regarding this election.
(4) Proprietary Information Invention Assignment Agreement
This document helps ensure that the company owns the technology and intellectual property developed by the founders and that the founders maintain the confidentiality of information they obtain in connection with their employment. This document also provides for non-disclosure provisions, invention assignment provisions, and non-compete or non-solicit provisions to give the company additional control. As more fully discussed in 4 Steps to Better Protect Your Ideas, this document helps outline who owns what intellectual property. Such IP protection can help a company be a more attractive investment.
The takeaway: Startup founders do not need the formalities of a shareholder or employment agreement. Startups generally lack structure at the outset, which can be helpful in addressing goals that remain dynamic and fluid at that stage. Such companies are built around ideas, people, and commitment, and initially can rely on general corporate laws and the simple suite of documents discussed above for governance.