Startup cofounding team due diligence for investors.

Series 3/4 legal set-up

In the cofounding investors series we look together on how to evaluate a startup cofounding team. How to identify any possible red flags and take care of the orange flags (mitigate the risks that do not present a deal breaker and you can take care of)

The next part of your due diligence is some of the legal set up - founders focus. 

A) Does the team have a written cofounder / shareholder agreement? 

Why does it matter? Depending on the jurisdiction where your startup is (or plans to be) incorporated, a cofounding (shareholding) agreement can be obligatory or optional. In case it is optional, it is still a big risk for the startup not to have it. It is also a big risk to not have a cofounder agreement prior to incorporation if this period has been longer than 3 months. Following the spread of the lean approach, many startups decide to test the idea before deciding to invest in incorporating a company. And from the business perspective that makes sense. You will work on the prototype, get users' feedback, check overall feasibility... The approach's pragmatic benefits though have some legal risks attached to it - from possible (widely) different assumptions of the cofounding team on their equity stakes, to the risk of diluted IP ownership. The much-recommended practice is to have a framework cofounder agreement prior to incorporation of the company. And definitely a shareholder agreement after the incorporation of the company.  And - you would want to have this agreement in writing.

 B) Is the IP assigned to the company / project?

 It is important to make sure that all the intellectual property which is being developed is clearly assigned and belongs to the project and not to the individuals working on it. Individuals come and go; the company / project does not. Without getting too technical on the definition of intellectual property and the concepts of legal and economic ownership of the intellectual property, what you need to know is that there should be clearly written documentation with everyone who has been working on the project that assigns the intellectual property to the project - that includes any interns, volunteers, candidate cofounders and advisors. 

 Intellectual property does not only include R&D, but has a much broader scope, including business know-how, valuable network information, and connection, customer or investor relationships. This is a somewhat more difficult risk to heal when discovered - the visible sign of this risk being a disgruntled ex-member of the founding team that did not leave on good terms and could claim (partial) ownership of the project’s intellectual property. Depending on the stage of neglect - this can be usually fixed. 

C) Is there an equity recovery framework?

 If founders leave, you must have clarity on what happens with their rights to equity ownership. Was this discussed? Was the equity already pre-allocated? Was there a cliff and vesting period set? Is there a good/bad leaver framework? In the worst-case scenario, you can imagine an equal equity split of 3 founders with no vesting period. And one of the founders leaving in the first 12 months. The remaining 2 founders have an early-stage project with 33% dead equity. For many, this is the end of this journey. The easy fix of this risk is the equity recovery framework - aka what happens if a cofounder leaves - in the written cofounder agreement. This is also the reason why VCs require a partial (or complete if a very early stage company) vesting scheme. As always, choose clarity over complexity here.