This article was originally published in e27, one of our partners for our December series of Facebook Live Q&A focused on Startups. You can read the original article HERE.
Let’s talk about Founder’s agreements — what do we need to know?
A Founder’s agreement is the document that binds and governs the relationships between the people who founded the company. A shareholder’s agreement may come subsequently, or it may be the same thing. The considerations are similar so discussed together here.
How a company structures the Founder’s agreement really depends on the nature of the startup business. A 50/50 split between two people is likely to be a failure, because it will be hard to make decisions when there are any kinds of disagreement later on.
One thing that Co-founders have to know is that not everyone is suited to become a co-CEO and not every decision needs the unanimous agreement of everyone.
Founders should start by allocating responsibilities and duties — this will help the startup get a sense of where the shareholding should fall. This can be contentious, because some people will get a larger share while others get less.
Typically, the person with the idea tends to get the most shares, since he or she has the vision and will determine the direction.
Then, define which specific decisions require consensus, since not all decisions require consensus.
I do not recommend DIY downloading and customizing a contract template unless leadership is legally trained and are able to advise on calibrating the contract to suit specific needs.
Lastly, I believe it better to take a preventive point of view instead of reactive point of view. You will spend more later on lawyers to extricate the startup from a tangled situation when it arises.
What do you think of ‘risk’ in a startup, from a lawyer’s point of view?
Everyone comes to a startup expecting it to succeed and not fail. The truth is, most startups will fail. In addition to that, someone who owns equity in the company may want to leave at some point.
Even though Founders should not expect these things to happen, it is important to plan for it and try to make any change as painless as possible. This is one of the reasons why people engage lawyers — to think about things like this. Lawyers are a devil’s advocate to tell you what can go wrong and help plan for that.
How do companies align co-founders to stay?
Co-founders most likely will have a ‘vesting period’ for their shares — shares are supposed to belong to them but they don’t actually get them (or Co-founders do get them but the company has a right to recall them until certain milestones or timelines are met). Typically, it involves a one year cliff, and four year vesting period.
A cliff means the Co-founder does not get any shares until they reach a first major milestone (in the above case, 25 per cent of the shares).
Vesting period means the rest (75%) will be apportioned for the rest of the three years (four years minus one cliff year).
Cliffs and vesting periods help aligns interest for a definite period of time. By the time vesting is up you will likely know where the company is heading. Sometimes some equity is tied to specific milestones like reaching a goal. Companies may also consider giving ‘refresher’ shares as a valued employee reaches the end of his vesting period to incentivise him or her to stay on.
Drag-along rights, Tag-along rights and cooling periods — what are they?
Drag along rights are tools majority shareholders can use to drag minority shareholders into a new setup against their interests (for example in a buyout scenario).
Tag along rights — the converse, minority shareholders have the rights to come along with the majority for any setup that is within their interests.
The value of lawyers in negotiations
Lawyers can be very valuable in helping negotiate beyond the basics of drafting and reviewing contracts.
Some law work might be able to do be done by robots, but negotiation is a very human thing. Lawyers will know what issues to look out for and help get an impartial view.
Actually enforcing a contract may be worth more effort than it’s worth; then there’s the efficient breach …
When thinking about how much to spend on lawyers, think about the objective. Is it about giving the contract formality? Or is there something the Founders intend to potentially enforce at some point?
Enforcement may take a lot of effort, and startups may choose to not enforce all contract breaches. This usually requires a cost-benefit analysis when deciding to take legal action to enforce a contract (e.g. a non-disclosure agreement).
What about deliberately breaching a contract?
On the other hand, there is also such a thing called efficient breach — if I make some calculations and see that it is more cost effective to breach a contract and pay the penalties (e.g. changing suppliers), it may be completely worthwhile.
For example, a claims amount in excess of US$10,000 will exceed the amount for a small claims tribunal and may make it a lot more work to aggressively claim a debt, which may deter another party from litigating.
What kind of lawyer should startups hire to help negotiate a funding deal?
Ideally, the person should have experience in both litigation and corporate.
Corporate lawyers are the ones who draft and review contracts. Litigation lawyers are the ones who take a case to court if a party decides to enforce a contract.
The lawyer should have a ‘pleasant face’ and can make deal go through but also go to court if the deal doesn’t go through (existing deal). Target someone with a reputation for having clout and influence in a negotiation setting.
What if a Founder hires a lawyer who worked against them in another case
This is not uncommon at all. It can be fairly useful to hire lawyers who were on the other side of the table and made you lose previously!
The losing party may want to hire this lawyer to be on their side in a different case later on.
Conflict checks — what are they? How does this affect me as a startup?
Ethics — can’t act for someone in one matter if the lawyer is already acting against the person in another matter because the lawyer/client then has privileged access to information.
A conflict check is a process by which a lawyer checks that he and/or his firm is not already representing the opposing party of a potential client. Law firms have automated records of clients and most lawyers will use email to do a second layer of checks. When you want to hire a lawyer, the lawyer MUST check that he is free from any conflict.
It is important to find a lawyer who has no conflicts, so that said lawyer can act completely in your and your company’s interest.
An interesting strategy to pre-empting conflicting out lawyers deliberately — intentionally hire very good lawyers on a small retainer so they cannot be hired by, say, a competitor.
Employee stock option program (ESOP) — when and how to go about it?
It can be intimidating and premature to think about ESOPs early or at the start.
Most founders feel like it is only worth discussing when they have some measure of success. However, many startups start thinking and planning for it at the start to set aside shares at the start.
There is no requirement ot give out the shares right away but they stay in reserve. Five to 10 per cent of the company’s 100 per cent equity is typically put away in ESOPs for employees
The Phantom Share arrangement
The ultimate question that founders face is how they should remunerate employees to align interest with the startup’s. ESOPs are one mechanism to achieve this, but not the only one.
Everyone wants to feel like they are part of something and not a workhorse. They want to be rewarded when company does well. When hiring employees to build strength in some areas and their needs to be incentive to retain them (to not go to competitor).
One strategy is to employ something called a Phantom Share arrangement.
A Phantom Share arrangement is purely contractual — no real shares are being transacted. It stems from the idea that at the start, primary concern of employees is cash when they think: “How much am I getting paid? Why does my bonus have to be a discretionary bonus that is an arbitrary number of months?”
The function of Phantom shares is to mimic how an ordinary share will perform so employee will get treated like a shareholder when it comes to dividends, but they get no voting rights or responsibilities of a shareholding employee.
How would this be put into effect? Founders can issue a phantom share certificate when hiring the employee. This can be terminated when they leave or upon certain conditions.
View phantom shares as a form of profit-sharing to align interests.
It is particularly useful if the startup doesn’t know for sure if the person is suitable to be a shareholder but the Founders want to put this person on a path to eventual shareholding.
Leadership may put clauses that allow the employee to progress to a proper ESOP after the employee has proved his or her worth.
The advantage to the startup — easier to issue, lower-risk because no actual shareholding at the start.
A VC is interested in investing in my startup — what now?
Many startups do not understand their bargaining positioning when it comes to VCs, who tend to have most of the bargaining power. Every startup thinks they are going to be the next Facebook but VCs are typically skeptical.
Startups are naturally very protective of their idea and it is common for them to insist that VCs sign a NDA at their first meeting. VCs see startups like them all the time (a dime a dozen) as they vet businesses they are interested in.
My suggestion is to not bring an NDA to the first meeting with VCs/investors; this is more appropriate at later stages of discussions. Reserve NDAs for contractors and manufacturers
Is it pragmatic for an early stage startup to apply for a patent on ideas? How to go about it in Singapore?
This depends on startup and idea seeking to protect. Not everything can be patented. It is a good idea to consult an IP lawyer from the start — they can check and advise. It is also very good to seek advice early!
How to enforce an NDA in Singapore?
A NDA (non-disclosure agreement) protects what is deemed to be confidential information. If that is breached, startups can seek damages or in special circumstances to get an injunction to order someone to do something or to stop doing something.
It can be quite expensive to enforce an NDA so do a cost-benefit analysis before doing so.
It can be particularly difficult or even impossible to enforce an NDA if the person or party is overseas, because it is hard to enforce (especially if the party has no assets here in Singapore). It can be hard to hit them where it hurts and may not make commercial sense.
That said, you still should have an NDA at certain junctures because people will consciously try not to breach an NDA that has been signed.
Examples of litigation cases between startups and investors and how to avoid it?
There aren’t many cases of litigation between startups and investors. This is often because it is too expensive for startups and there is not much for an investor to go after in a startup.
However, disputes do arise (for example, an investor investing in a second startup that is very similar to the startup they first invested in to hedge their bets). You may want to negotiate exclusivity to avoid this scenario.
Are non-compete clauses enforceable in Singapore?
Non-compete clauses are clauses in an employment contract that limit and prevent an employee with access to privileged information from entering into or starting a similar business in competition with the company they are leaving, or from joining a competitor. It is usually bound by a time-period.
Non-compete clauses are not only applicable to startups. Companies big and small face this challenge. Competitors exist and will try to get the best employees.
What happens if someone valuable in your company moves and take valuable know-how? Employers try to lock employees down with non-competition clauses.
Be careful when dealing with non-compete clauses in Singapore — the Singapore courts deal such clauses with disdain (does not look favorably on clauses that curtail the liberty of a person to work). The non-compete clause has to be very well defined. To pass muster, must be as small and narrow as possible.
The major ingredients are duration, industry, trade and geography. I recommend that Founders state upfront who is the competition to avoid any ambiguity. The Singapore courts will not reword the clause so if it is not worded properly they cannot rewrite it and they will strike the whole thing down.
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You can watch this Facebook Live interview HERE.
Read more about Samuel Ng HERE. Sam is available for a Quick Consult to advise you on a specific legal matter and answer your questions for your startup on the phone for a transparent, flat fee starting at S$49 HERE.
This article is written by Gabriel The from Asia Law Network.
This article does not constitute legal advice or a legal opinion on any matter discussed and, accordingly, it should not be relied upon. It should not be regarded as a comprehensive statement of the law and practice in this area. If you require any advice or information, please speak to practicing lawyer in your jurisdiction. No individual who is a member, partner, shareholder or consultant of, in or to any constituent part of Interstellar Group Pte. Ltd. accepts or assumes responsibility, or has any liability, to any person in respect of this article.
