Do Co-Founders Need an Engagement Ring?

I was recently asked about a founder’s agreement for a new business before they incorporated so I thought this would be a good topic for this month’s blog post. It is possible to have a contract among founders who intend to form a corporation or an LLC but have not yet done so. These are sometimes called Pre-Incorporation Agreements or Pre-Formation Agreements. While they can be beneficial, there are also serious drawbacks to using one.  This post will discuss what they are, why they are sometimes used and what risks are associated with them.

What are Pre-Incorporation Agreements?
Pre-Incorporation Agreements (for corporations) and Pre-Formation Agreements (for LLC’s) – I’m just going to call them both Pre-Incorporation Agreements for purposes of this post – are agreements between people who want to start a business and form a company. They haven’t formed it yet, but they want to get certain terms set out and agreed upon before they move any further along – like an engagement ring for getting married.

Pre-Incorporation Agreements should not be confused with Post-Incorporation Agreements – which are called Shareholders’ Agreements (for corporations) and Operating Agreements (for LLC’s). These kinds of agreements are made after the company is officially formed and the Articles have been filed with the state. Post-Incorporation Agreements are a lot more detailed and cover more topics than Pre-Incorporation Agreements.

Why would someone have it?
First, it makes people focus on the most basic and essential issues for creating a business – up front before any money is spent getting it formed. How much will each person own? Who will be responsible for what? What will their titles be? How much money will each person put in? Will there be any sweat equity required – if so, how much? Will there be any property contributed – tangible or intangible? These are all issues that should be ironed out as much as possible at the beginning. Even though it may change before it’s all said and done, and even though they may not have all of the answers yet, going through the process of a Pre-Incorporation Agreement forces the attention and discussion on these most basic issues. So that’s a good thing.

Second, it sets accountability for that time period between getting the idea put together and actually getting the company formed. This time period may be short or it may be long. Either way, a Pre-Incorporation Agreement can deal with the responsibilities, promises, expectations and goals that should be met during this time period.

What to Watch Out For:

You may think that a Pre-Incorporation Agreement would be more beneficial if there’s a long period of time between idea and formation – but that’s not the case. If there’s an “official” agreement in place, it’s easy for people to think that they can go ahead and start conducting business – which is a very bad idea. Doing business before the business entity is actually formed creates personal liability for the business’ activities and obligations. Planning is one thing, but actually conducting business is quite another.

As a business develops, it naturally acquires and creates assets – both tangible and intangible. But if the business entity is not yet formed, there is no business to “own” these assets and most of the time they will belong to the people individually. For example, in starting a business there are a lot of intangible assets developed – websites, marketing materials, product/service development, etc. Normally, each person who creates these intangible assets has an ownership interest in them – which can cause problems if those ownership interests do not get transferred to the business entity once it’s formed – for whatever reason (lack of documentation, person leaves the group and never joins business, disagreements, additional demands, etc.). If that happens, there’s now a “business” asset that’s sitting outside the business.

Other issues and downsides to consider: How will the taxes be handled? What if the Pre-Incorporation Agreement technically formed a partnership and that’s not what was intended? What if the equity splits aren’t quite ready to be set in stone yet?

Bottom Line = Pre-Incorporation Agreements are beneficial in certain circumstances, but there are significant pitfalls involved so it’s a good idea to speak to an experienced business attorney before you decide.