On The Psychological Side Of The Legal Aspects Within The Entrepreneurial Journey - Part 1

Guy Lachmann,
Senior Partner, Pearl Cohen Law Firm

The upcoming series on the podcast will discuss the psychological aspects 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 a lot to both. I did my internship at Herzog Fox & Neeman, in the Private Clients department - a department that treats all the wealthy people we all read about in the paper and whose psychological aspects are the basis for all their personal legal conduct in financial agreements, trusts, wills, assets allocation and more. After graduation I left the profession. But a lot of the principles and thinking ways have remained with me and are still guiding me through the years till these days.

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 do 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 either a lawyer or a psychologist - but bring in 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 legal aspects of the entrepreneurial journey, and 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 should be much more than just knowledgeable in laws and case law; he should also be a person who really sees you, your values, your style and helps you advance the big goal you are striving for, over small commercial insistences that don’t promote and can ruin the deal and the startup.

Disclaimer (I am after all still an ex-attorney) - everything that will be written in the next three chapters is in the nature of providing knowledge that will help you shed light on the field and reflects our perspective and worldview, and is not a substitute for personal legal advice for you. 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 and is done on the opinion of the speakers only.

>>> The Founders’ Agreement

The founders' agreement is the contract signed by the entrepreneurs on departure. This is one of the most critical and impactful agreements on the venture, and could shape its future.

The purpose of the agreement - to arrange things between the founders, and an indication of their maturity, seriousness and decision to formalize their relationship.

Companies that started with a properly made founding agreement - these are companies whose 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 of what we sign on.

3. It has no priority - 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 of these barriers cause reluctance, avoidance and/or procrastination - behaviors whose results usually don’t benefit us or the startup's progress.

Also downloading templates of founders’ agreement from the Internet - is really not recommended. There’s a difference between American and Israeli law, for example, and American templates don’t fit the Israeli legal entity 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 and professional hand and not in a nutshell.

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 in order 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 your soul and all you got - these are relationships that are life changing. Therefore, one can look at the founders’ agreement as similar to a prenuptial agreement. The purpose of these agreements is not only to define what happens when the relationship hits a wall or for a rainy day, but also when everything is good, 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 matters; 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 it seriously and wholeheartedly.

"There are only two things certain in this world: taxes and death," said Benjamin Franklin.

Taxes are one of the significant elements that can negatively impact companies and deals, so it’s very important to give it the right attention. Also in tax matters - many of the tests are behavioral tests according to which tax considerations are determined (such as residency, center of life test, etc.). 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 property, the transfer of property is the same as its sale, and the consideration allegedly paid is the shares issued at the time of the establishment of the company. The issuance of shares actually has a price determined in accordance with the value of the company and the income and expenditure of assets, 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 move DD properly - 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 as a result of 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 where in 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 and not be right.

When you insert a founder 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 partner has joined - there is complexity, and we need to create the creative mechanism that will suit the joining of the new founder to 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, and on the other hand - you want to give the right compensation, so it 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 the 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.

>>> Vesting, Cliff

The classic vesting idea - we’ll create an equation that is influenced by the time component - 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 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 mental elements .

2. Proper definition of the roles

It’s not enough to just assume the 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 and issue, and there are many opinions and many ways to settle it. But there are some important anchors - for example, defining the decisions that require consensus - agreement on everything. For example, closing the company / bringing in an external investment that requires dilution and / or sale - it is desirable that these will be decisions that everyone participates in and agrees on. 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. Therefore, the DNA of the entrepreneurs and the connection with the partners is so important - to produce these agreements as well.

And what happens when the doctrine collapses and there are 2 founders that hold 50-50 and they fail to reach agreements and reach what is called a deadlock? so either through extreme pressures and changes - some movement is created and then comes the separation, but there are also those in the "cut off one's nose to spite one's face" approach - where no one is willing to let go. We will address this later.

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 such and such claims - for example previous employers and/or academia.

6. Financial management - a precise definition of who makes decisions regarding money and in what way.

7. Time

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 our 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 screwed.

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