How should start-up founders structure their legal relationship?

Setting up a start-up often begins informally – with an idea, a prototype and an oral arrangement between friends or professional partners. At the outset, attention is focused on the product and the funding, while the legal relationships are left “for later”. However, it is precisely this that may become one of the most serious risks to the project.

Where it has not been settled in advance who owns what, what effort each must put in, who makes the decisions and what happens on departure, an ordinary professional disagreement easily escalates into a dispute over control of the entire company. The problem is particularly serious if a founder who has left retains a significant share, or if the code, the trade mark and the domain name turn out to belong to that founder personally.

Relations between the founders should not be regulated solely through the registration of the company. A set of documents is usually needed: articles of association, a founders’ agreement, intellectual property assignment agreements and agreements defining each founder’s role and remuneration.

Does the company need to be incorporated at the very beginning?

Not every idea requires a company to be set up immediately. If the founders are still discussing the project and are not carrying on any actual business activity, their working relationship can initially be governed by a preliminary agreement and confidentiality arrangements.

However, the incorporation of a company should not be postponed where:

• the development of significant intellectual property begins;
• contracts are concluded with customers or suppliers;
• employees and external contractors are engaged;
• payments are accepted;
• expenses and obligations are incurred;
• an application for investment or funding is forthcoming;
• personal data are processed;
• the product carries regulatory or consumer risk.

The business’s contracts, revenue, intellectual property and other key assets should generally be held by the company. If the activity continues to be carried on by the founders personally, uncertainty arises as to who is the party to the contracts, who is liable for the obligations and who owns the work product and related intellectual property rights.

What legal form should be chosen?

In Bulgaria, a start-up is most often incorporated as a limited liability company (OOD). This form is familiar, relatively easy to administer and allows relations between the shareholders to be regulated by the articles of association.

However, an OOD has limitations that become apparent with more complex funding. A transfer of shares requires a special form, the admission of a new shareholder is subject to a resolution of the general meeting, and creating different classes of equity and employee incentive mechanisms is more difficult.

Following the amendments to the Bulgarian Commerce Act, there is also the Bulgarian variable capital company (VCC; дружество с променлив капитал, ДПК). It was conceived precisely as a more flexible form for start-up and growing enterprises. The law allows different classes of shares, special rights, restrictions on transfer, rights to acquire shares and more flexible employee participation.

A VCC is not automatically the best choice. Its eligibility for the particular enterprise, the future investment structure, the ongoing administration and investors’ expectations should be assessed. For a project that will soon seek institutional funding or participation by foreign funds, it is useful to plan from the outset whether the Bulgarian company will be the principal company or whether a foreign holding structure will be created in future.

The choice between an OOD, a VCC and a joint-stock company (AD) should not be based solely on the minimum capital or the registration costs. The following are important:

• the method of future funding;
• the ability to issue new equity;
• the rights sought by investors;
• the employee incentive plan;
• the restrictions on transfer;
• a possible exit through a sale of the company;
• the tax and international consequences.

Are the articles of association sufficient?

The articles of association are the company’s principal constitutional document. For an OOD, their mandatory content is laid down in Article 115 of the Commerce Act. They set out the shareholders, the business name, the seat, the scope of business, the capital, the shares, the management and other fundamental matters.

For a start-up, a standard template for articles of association is usually not sufficient. It regulates the formal existence of the company, but rarely answers the practical questions that arise between the founders.

It is advisable for the articles of association to include clauses on:

• the allocation of capital and votes;
• the management bodies;
• who may bind the company and whether they must act jointly;
• the majorities for important decisions;
• restrictions on the transfer of shares;
• the admission of new shareholders;
• the other shareholders’ pre-emption right;
• additional cash contributions;
• the grounds for terminating participation;
• the distribution of profit;
• special rights of certain shareholders, where the law and the chosen form permit this.

However, it is not appropriate for some of the arrangements to be public. The articles of association of an OOD are published in the Commercial Register and are accessible to anyone. They should not unnecessarily include detailed business plans, technologies, internal financial indicators, personal commitments or confidential arrangements.

For this reason, alongside the articles of association, a separate agreement between the founders is usually concluded – a founders’ agreement or shareholders’ agreement.

What is a founders’ agreement?

A founders’ agreement is a contract that regulates the founders’ relations in more detail than the articles of association. It may be concluded before the company is incorporated or immediately afterwards.

It may regulate:

• roles and specific responsibilities;
• the minimum commitment to the project;
• the allocation of ownership;
• the future acquisition of shares;
• funding by the founders;
• key decision-making;
• intellectual property rights;
• confidentiality;
• conflicts of interest;
• the departure of a founder;
• the sale of shares;
• the admission of an investor;
• the resolution of deadlock and disputes.

The agreement cannot replace all the corporate actions required by the Commerce Act. It cannot by itself transfer shares if the law requires a special form and registration. Nor can it override the mandatory powers of the general meeting.

If the company is not a party to the agreement, its obligations cannot, as a rule, be created merely by a contract between the shareholders. It should therefore be decided whether the company itself will join the agreement.

It is particularly important for the content of the founders’ agreement to be consistent with the articles of association. If one document provides for one majority or transfer rule and the other for a different one, there is a risk that a corporate resolution will be valid but that one of the shareholders will bear contractual liability for the way in which that shareholder voted.

How should the shares be allocated?

Equality between the founders seems fair, but a mechanical 50/50 split is not always appropriate. It may lead to deadlock when the two fail to reach agreement and neither has a majority.

When determining the shares, account should be taken of:

• the funds initially invested;
• the technology or business already created;
• future work and time commitment;
• the professional risk assumed;
• responsibility for management;
• access to customers, partners and capital;
• each founder’s role in future development;
• the likelihood that participation by new founders, employees or investors will be needed.

The biggest mistake is to allocate all the shares definitively at the very beginning, without a mechanism for subsequent change. If one founder leaves after three months and the other develops the project for a further five years, the first may keep half of the company and block an investment or a sale.

A common solution is a vesting mechanism under which a founder’s equity interest vests over time or on achieving agreed milestones.

What is vesting?

Vesting determines when a founder becomes entitled to an equity interest over time or on achieving agreed milestones. Under reverse vesting, shares are issued or transferred upfront, but the unvested portion may have to be transferred back if the founder leaves early. The typical model provides for a four-year period with a one-year initial threshold, known as a cliff.

If the founder leaves before the first year has expired, they retain none of the intended stake, or only a very small part of it. Once the cliff has expired, part of the shares is deemed to have vested, and the rest vest gradually – for example, monthly or quarterly.

Vesting may also be linked to specific results:

• completion of a prototype;
• obtaining a licence;
• reaching a certain level of revenue;
• attracting investment;
• concluding key contracts;
• reaching a certain number of users.

In a Bulgarian OOD, the mechanism should not be copied literally from an American contract. The shares already form part of the capital, and their transfer is subject to mandatory requirements. Vesting needs to be implemented through a permissible contractual and corporate arrangement – for example, options, predetermined transfer obligations, a buy-back where applicable, conditional rights or another suitable structure.

The documents should set out in advance the price, the time limit, the form and the procedure for the transfer. A general promise that the departing founder “will return the unearned shares” may prove difficult to enforce.

What happens if a founder leaves?

The agreement should distinguish between at least two categories of departure – good leaver and bad leaver.

A good leaver is usually a founder who leaves for an objective and valid reason, for example:

• prolonged illness;
• permanent inability to work;
• death;
• termination of their role through no fault of their own;
• a mutually agreed withdrawal;
• another reason specified in advance.

A bad leaver may be a founder who:

• leaves voluntarily too early without an agreed transition;
• commits a material breach of the contract;
• misuses property or information;
• engages in competing activity in breach of a permissible obligation;
• systematically refuses to perform the role they have taken on;
• intentionally causes harm to the company;
• is dismissed for serious misconduct.

The consequences may differ. A good leaver usually retains the part of the stake that has already vested or sells it at a fair market price. For a bad leaver, an obligation to sell at a lower price may be provided for, to the extent that the arrangement is lawful, proportionate and enforceable.

It should also be settled who may acquire the shares – the remaining founders, the company, an investor or a designated third party. The mechanism needs to be consistent with the statutory rules on the transfer of shares and with the restrictions of the relevant corporate form.

Who manages the company?

Share ownership and management are different matters. A founder with 50% of the capital is not automatically a manager, and the manager may have broad representative authority regardless of internal restrictions.

The founders should determine:

• who will be the manager;
• whether the managers will represent the company jointly or severally;
• which decisions may be taken in day-to-day operations;
• which actions require prior approval;
• what limits will apply to expenditure and contracts;
• who has access to the bank accounts;
• who appoints key employees;
• how the budget and the business plan are approved;
• when the manager may be replaced.

Joint representation ensures control but may slow the business down. Sole representation is operationally easier but creates the risk that one manager will take on a significant obligation without the knowledge of the others.

An internal arrangement that the manager is not entitled to conclude contracts above a certain value without consent does not always protect the company as against third parties acting in good faith. That is why control should be backed by an appropriate manner of representation, banking rules and internal procedures.

Which decisions should require a special majority?

It is not necessary for all decisions to be unanimous. That may make the company unmanageable. Unanimity or a qualified majority should be reserved for decisions that may materially change the founders’ investment.

The following are usually designated as reserved matters:

• a change to the scope of business or the core business model;
• a capital increase or reduction;
• the issue of new equity;
• the admission of an investor;
• the sale of material assets;
• the sale of the company;
• taking out a significant loan;
• the granting of security;
• a change to the budget above a certain threshold;
• disposal of intellectual property;
• related-party transactions;
• the appointment and removal of a manager;
• the distribution of dividends;
• dissolution or liquidation;
• commencing or settling significant litigation.

The list should be sufficiently specific. If every purchase or contract requires everyone’s consent, operations may come to a standstill.

How is deadlock between the founders resolved?

Where stakes are equal, a pre-agreed deadlock mechanism is needed. Without one, a dispute may make it impossible to approve a budget, an investment or a key contract.

The procedure may include several successive stages:

1. internal negotiations between the founders;
2. a meeting with an independent adviser or mediator;
3. a time limit for submitting alternative proposals;
4. a right for one of them to offer to buy out the other’s share;
5. sale or dissolution of the company as a last resort.

There are mechanisms such as Russian roulette and Texas shoot-out. Under the first, one founder names a price at which they are prepared either to buy the other’s share or to sell their own. The other chooses whether to buy or to sell at the same valuation. The mechanism encourages the setting of a realistic price, but it may be unfair if one founder has significantly greater financial resources.

The deadlock clause should therefore take into account the financial position, access to information and role of each founder. Automatically copying an aggressive mechanism may allow the stronger party to oust the other at an artificially low price.

Who owns the intellectual property?

For a technology start-up, this is often the most important question. An investor does not merely acquire a stake in a legal entity, but expects the company to own the technology, the trade mark, the design, the domain name, the databases and the other key assets.

If a founder created code, designs or content before the company was incorporated, the rights do not pass automatically to the new company. An express assignment, or the grant of sufficiently broad rights of use, is required.

Each founder should declare:

• what materials they created before the company was set up;
• what they are contributing to the project;
• whether third-party libraries or development work have been used;
• whether they have obligations to a previous employer;
• whether they use open-source components;
• whether any third parties have rights in the product.

For computer programs and databases created in the course of an employment relationship, Article 14 of the Copyright and Related Rights Act provides that, unless otherwise agreed, the copyright belongs to the employer. This rule must not be mechanically carried over to a founder who is not an employee, or to an external contractor.

In a contract with a freelancer or another company, the rights in the results should be expressly provided for. Payment for the development does not in itself guarantee that the start-up has acquired all the necessary rights.

Where applicable, the following should be registered in the name of the company or transferred to it:

• domain names;
• trade marks;
• code repositories;
• cloud accounts;
• profiles on applications and platforms;
• design files;
• customer databases;
• technical documentation;
• contracts with developers;
• rights in inventions and industrial designs.

Access to these assets should not depend on a single founder’s personal email or telephone.

How should confidential information and know-how be protected?

The agreement should specify which information is confidential, for what purposes it may be used, to whom it may be disclosed and what happens to it on departure.

To benefit from the special protection of the Trade Secrets Protection Act, it is not enough for information simply to be valuable or non-public. Under Article 3, it must have commercial value because it is secret, and its holder must have taken measures to safeguard it.

Such measures may include:

• confidentiality agreements;
• access restricted according to role;
• protection of information systems;
• rules on storage and sharing;
• marking of sensitive documents;
• logging of the access granted;
• return and deletion of information on departure.

A general clause stating that “everything is confidential”, without real protective measures, may prove insufficient.

Can competing activity be prohibited?

While participating in the company, a founder may undertake not to develop a competing project, not to divert customers and employees, and to disclose their conflicts of interest.

The prohibition after departure should be formulated carefully. An unlimited prohibition on practising a profession or working in an entire sector may be invalid. This is particularly important where the founder also has an employment relationship. The Supreme Court of Cassation holds that a clause in an employment contract which restricts the employee’s competing activity after the contract is terminated is contrary to the constitutionally protected right to work and is invalid – see Judgment No. 60 of 13 March 2012.

Protection should be targeted more precisely at:

• trade secrets;
• confidential information;
• the diversion of specific customers;
• the solicitation of key employees;
• the use of the intellectual property;
• the misuse of the company’s business opportunities.

Where a restriction between shareholders is provided for in connection with the sale of a stake, it must be limited in subject matter, territory and duration and must protect a legitimate interest.

How is funding by the founders regulated?

Founders often invest different amounts and bear expenses personally. It should be clear whether each amount constitutes:

• a contribution to the capital;
• an additional cash contribution;
• a loan to the company;
• a payment on behalf of the company that is reimbursable;
• an investment in return for future shares;
• non-repayable funding.

If this is not documented, a dispute may later arise as to whether the founder has a claim against the company or has borne the expense as part of their commitment.

The following should also be agreed:

• the budget for the initial period;
• the maximum amount each founder undertakes to provide;
• the consequences if someone fails to contribute what was agreed;
• whether additional funding changes the shareholdings;
• on what terms loans are repaid;
• who approves external funding.

It is not sensible for every additional expense of one founder to increase that founder’s percentage automatically. This may lead to opaque dilution of the others.

How should a start-up be prepared for a future investor?

A good contractual framework should provide that, in the event of an investment, the founders will assist with:

• legal and financial due diligence;
• a capital increase;
• the admission of a new shareholder;
• amendment of the articles of association;
• the signing of investment documents;
• the creation of an employee equity incentive plan;
• providing customary representations and warranties.

It should be clear how future dilution is allocated. As a rule, it affects the founders proportionately, but different mechanisms may be agreed.

Transfer clauses are also important:

• right of first refusal;
• pre-emption right;
• lock-up period;
• right to join a sale – tag-along;
• obligation to join a sale – drag-along.

Tag-along protects the minority shareholder. If the majority shareholder sells their stake, the minority shareholder may join the transaction on the same terms.

Drag-along allows a qualified majority, on a sale of the company, to oblige the remaining shareholders to sell as well. Without such a clause, the holder of a small share may block a deal for the entire company. The mechanism should contain safeguards concerning the price, the terms, the liability and the warranties that the minority shareholders give.

Do founders need separate contracts for their work?

The status of shareholder, manager and person performing work is not one and the same. A single founder may simultaneously hold shares, manage the company and perform a technical or commercial role.

It is necessary to determine the legal basis on which the founder performs work and receives remuneration:

• an employment contract;
• a management agreement;
• a service agreement;
• activity as a self-employed person;
• a combination of permissible relationships.

The choice has implications for social security, taxes, working time, leave, liability and termination. Holding shares does not replace an employment contract or a management agreement.

Remuneration must also be kept separate from dividends. A salary or remuneration for management is owed for the work performed, whereas a dividend may be distributed only where there is a profit and a duly adopted resolution.

Conclusion

Relations between the founders should be regulated before any dispute arises and, where possible, before the project has acquired significant value. The key question is not only who receives what percentage, but what each must do to keep it, who makes the decisions and what happens if the collaboration comes to an end.

A good structure includes an appropriate legal form, mutually consistent articles of association and founders’ agreement, the assignment of the intellectual property to the company, vesting, and clear rules on management, funding, departure and the resolution of deadlock.

The aim is not to anticipate every future conflict. It is necessary to create a working mechanism that allows the start-up to continue to function even when relations between the founders change.