Laying the Legal Groundwork: How to Limit Co-Founder Legal Disputes

Two pieces of a puzzle fitting together

There are many legal intricacies to starting a business, making being a startup founder even more difficult than it already is. The legal framework of everything, from choosing an entity form (LLC., C-corporation, or S-Corporation), deciding where to form your entity (for example, Delaware or your home state), issuing shares, seeking investors (term sheets, share purchase agreements or notes), hiring your first employees, and the like can be daunting.

The reality is that every legal mistake at the start often costs exponentially more to fix later compared to simply paying to have it done correctly in the first place. Legal disputes between co-founders/business partners is an unfortunately common problem when there is a difference of opinion as to which direction the company should take. Let’s review some of the ways you can handle co-founder disputes and prepare for dispute resolution.

Clarity From the Beginning

If you are like most entrepreneurs, you have ideas, ongoing projects, or ventures which may be a result of a joint effort. Deciding whether you wish to turn a project or venture into a company is something that is often most easily done at the very start. However, sometimes you realize later on that creating a company is what you wish to do. In these cases, it is important to ensure that your interests are aligned or clarify what each of you are looking to do with the project moving forward.

Having an email conversation or creating a written agreement, such as a founder’s agreement (also referred to as co-founder agreement), at the very start of the project lays excellent groundwork. It should state, among other things, that if the startup becomes a company, you and your co-founder will own it and split the ownership 50/50 (or whichever way you decide to split founder equity).

This assumes that all involved want to create a company. If one person decides against turning it into a company, then having language in the initial email or document saying that the other individual has the right to buy out the departing founder in the first year for a certain amount of money can help. Having something in writing is better than nothing, legally speaking. 

The agreement should also establish management and legal decision-making at the startup. By creating a process to determine how business decisions are made, you can help prevent potential co-founder disputes. Dividing the decision-making power between co-founders is often essential. How you split it up could depend on how much of the company each partner owns. Many founder’s agreements make it clear who decides on what, with other methods set up for other decision-making moments, such as consensus voting and/or a simple majority vote.

Cleaning Up During Creation

Once you have decided to pursue the company’s creation, it is time to clean up any future issues. This means finding all the people involved and properly attributing and compensating them.

Clarifying what intellectual property (IP) belongs to the company and in what manner the individuals who no longer wish to be a part of the project will be compensated are good steps to take. This compensation can include equity in the company (whether in the form of an outright grant or options), an upfront cash payment to “purchase” the IP, or a license or “right to use” agreement.

Ensuring that this process is overseen by a lawyer can help mitigate the expensive costs of oversight down the road.

The Cost of Doing It Wrong

For larger publicly traded companies the cost of not handling these initial phases can be astronomically expensive. There are cases where individuals who were there in the beginning of the project, but who contributed little or spent little time there at all, will come back years later calling themselves a co-founder and demanding a share of the profits. This is often to the tune of millions of dollars, if not more.

The reasoning behind assigning the IP to the company during the creation process is to prevent these claims down the road. Even if that individual did little work, something they stated during that initial period of time gives them legal claim to compensation unless legally stated otherwise.

Documenting contributions, potential future roles in the company, and notable ideas you had in emails is important to ensuring your legal claims for the future.

Professional Assistance

While having your roadmap laid out and your contributions demarcated is extremely important when trying to avoid founder disputes, getting professional legal advice can help to properly document your understandings with your co-founders and is well worth the cost.

Speaking with experts who understand the pitfalls and pain points for this complex process can help alleviate a large amount of concerns. Many large law firms work with extremely small entities at the early stages of their formation, and would be invaluable to your company’s creation in case you find yourself in the middle of legal issues with a co-founder.

Make sure to read through the rest of our Laying the Legal Groundwork series to help find information to make your company more successful.