Preincorporation Agreements | What Are They? | Do We Need Them?

Recently I have had several entrepreneurs ask me about preincorporation, or founders', agreements. To be honest, this surprised me. In the Silicon Valley emerging technology company practice, preincorporation agreements are fairly rare. But since the question came up, I thought I would share my thoughts on the matter with a broader audience.

So what is an preincorporation agreement? In simple terms, it's an agreement among co-founders about the terms on which they wish to incorporate their business. Why are preincorporation agreements rare? Instead of sitting down with an attorney to formulate the terms of the agreement, it is generally more efficient and cost-effective to use that attorney's time to incorporate the business on the terms you and your co-founders agree to. Essentially, incorporating sooner saves on the cost of drafting a solid preincorporation agreement that can withstand being challenged in court in the worst case.

That said, when might you wish to draw up a preincorporation agreement? The only time when a preincorporation agreement makes sense is in a situation where a group of co-founders is beginning to work on a project and decides to put off incorporating the venture for some time (perhaps 6 months or a year). While I would generally discourage this course of action, there are instances where the co-founders may, having weighed their options, decide to delay forming a company. To improve your venture's chances of survival through a long preincorporation phase, it is prudent to enter into a preincorporation agreement, stating both the obligations of the co-founders' in the interim period, and the terms on which they wish to incorporate the venture at a future time.

The terms that go into a preincorporation agreement are really up to the founders. The more detailed that they make the original agreement, the less they have to discuss/ negotiate/ argue over later, when the time comes to form and operate the company. Of course, the flip side of that coin is, if you get very specific and circumstances change (which is very likely to happen), everyone needs to agree to amend the agreement, and that can be its own can of worms.

Generally, you can think about the agreement in phases: (1) preincorporation, (2) formation, and (3) post-formation / operating the company. Below is an outline of some of the terms you may wish to include in each of the categories, keeping in mind that your individual business may have different needs and requirements.

(1) Preincorporation

• Time commitment by each cofounder (pre-formation)
  
• Deliverables / project description for each cofounder
  
• Initial expenses / capital contributions by each cofounder
  
• Consequences for any cofounder who fails to comply with the above terms
  

(2) Formation

• Company name, state of incorporation, whether to reserve the name
  
• Deadline to form the corporation
  
• Authorize shares & founder stock grants, vesting, restrictions
  
• Board of Directors
  
• Officers
  
• Ancillary agreements (e.g., to sell stock, transfer IP, account for bootstrapping funds, etc)
  
• "S" status election for corporation
  

(3) Operations

• Time commitment by each cofounder (post formation)
  
• Positions of cofounders in the company, salary (if relevant)
  
• Distribution of initial capital by category of expense
  
• Authority to write checks
  
• Authority to enter into contracts

Beyond these timeline-centered categories, the cofounders should think through the term and termination of their agreement. What happens if they don't incorporate by the time they state in the agreement? What happens if one of the cofounders wants out either before or after producing the preincorporation deliverables? Who owns the intellectual property generated during the preincorporation phase by the individual cofounders?

You can see that the level of detail and complexity of this agreement can be quite high. If it is not, how valuable will this agreement be in settling disputes among cofounders? If it is, how much time and expense will it take to put together the agreement? Bottom line is, unless there is a really good reason for you to put off incorporating once you've embarked with your cofounders on an entrepreneurial venture, skip the preincorporation agreement and take the plunge by incorporating.

And, my shameless plug at the end: whichever course you choose, or to discuss the best course for your company, Emergence Law Group is available to help.

Inna Efimchik

Emergence Law Group, specializing in assisting emerging technology companies in Silicon Valley and beyond, provides incorporation, financing, and licensing services as well as general corporate counseling.