Corporate Law 12 min read By Adv. Or Elyashiv

Founders and Shareholders Agreements: Essential Clauses That Can Save Your Startup

A comprehensive guide to the critical clauses in founders and shareholders agreements that will protect your startup during crises and facilitate investment rounds

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Why Every Startup Needs Founders and Shareholders Agreements from Day One

A 28-year-old tech founder starts a company with two partners. After two years of hard work and promising product development, one founder decides to leave just before a crucial funding round. Without proper founders agreements, he could take 33% of the company with him - destroying the investment opportunity.

This scenario occurs in Israel more often than you'd think. Founders and shareholders agreements aren't just legal paperwork - they're life insurance for your startup. They define who owns what, what happens when someone leaves, how critical decisions are made, and how to handle conflicts.

Under the Companies Law, 5759-1999, founders of an Israeli company can regulate their relationships through shareholders agreements that supplement the company's articles of association. These agreements allow much more flexibility than standard articles and are particularly suited to the changing needs of startups.

In this article, we'll review the most critical clauses every founders agreement should include, the provisions that can save the company during a crisis, and the common mistakes that can prove costly.

Vesting Mechanisms: How to Protect the Company When a Founder Leaves

One of the most critical clauses in any founders agreement is the vesting mechanism. The concept is simple: founders' shares "vest" gradually over several years. If a founder leaves before the end of the period, the company can buy back the unvested shares at a low or nominal price.

Standard Vesting Structure

The most common mechanism is "4 years with a 1-year cliff." This means:

Practical example: A founder receiving 1,000,000 shares who leaves after 30 months would keep approximately 625,000 shares (25% after the first year + 18 additional months of 1/48th of shares each month).

Single Trigger vs. Double Trigger

There are two main types of vesting mechanisms:

In a Double Trigger scenario, if the company is sold after two years, all shares might vest immediately - a mechanism that protects founders in case of early acquisition.

Different Departure Scenarios

The agreement should distinguish between different types of departure:

The definition of "good reason" for resignation might include significant role reduction, drastic salary cuts, or relocation of workplace to a distant location.

Fair Equity Distribution and Managing Founder Disputes

One of the most complex questions in starting a startup is dividing equity among founders. The division should reflect not only financial investment, but also expected contribution, experience, professional networks, and time invested.

Criteria for Equity Distribution

Proper distribution should consider several factors:

It's important to understand that equal division (e.g., 33%/33%/33%) isn't always fair or practical. Sometimes one founder contributes significantly more and deserves a larger share.

Decision-Making Mechanisms

The agreement should regulate how important decisions are made:

It's worth clearly defining which decisions require which approval levels. Examples of decisions requiring supermajority:

Dispute Resolution

When founders disagree, the business suffers. The agreement should include graduated dispute resolution mechanisms:

  1. Direct negotiation: Parties try to resolve within 30 days
  2. Mediation: An agreed mediator tries to reach a compromise
  3. Arbitration: A professional arbitrator decides the dispute

Advantages of arbitration over court: Faster process, privacy, and ability to choose an arbitrator with startup expertise.

Shotgun Clause ("Mexican Standoff")

For unsolvable disagreements, there's an effective mechanism: one founder offers to buy the other's share (or sell their share) at a specific price. The other founder chooses whether to buy or sell at that same price. This mechanism ensures fair valuation because the proposer knows they might end up being the buyer.

Drag Along and Tag Along Rights: Protection in Sale and Exit Transactions

When it's time to sell the company or receive an acquisition offer, conflicts can arise between shareholders. Some want to sell, others prefer to continue, and the potential buyer demands to purchase 100% of the company. Drag Along and Tag Along rights solve these problems.

Drag Along Rights: "All or None"

Drag Along rights allow majority shareholders (or a supermajority) to force minority shareholders to sell their shares alongside them, under the same terms. This prevents a situation where a small minority blocks a deal that's good for all shareholders.

The right is typically exercised as follows:

  1. Majority holders receive an acquisition offer from an external party
  2. They decide to accept the offer
  3. They notify minority holders of their intention to sell
  4. Minority holders must sell under the same terms

Important conditions for exercising Drag Along:

Tag Along Rights: Minority Protection

Tag Along rights protect minority shareholders when majority holders sell their stake to a third party. They allow minority holders to "tag along" in the transaction and sell a proportional part of their shares under the same terms.

Example: A founder with 60% of the company sells half of their holdings (30%) to a strategic investor. Minority founders can use Tag Along rights to also sell a proportional part of their holdings to the same investor, at the same price.

The right is exercised as follows:

  1. Majority holder announces intention to sell to a third party
  2. Minority holders can demand to be included in the transaction
  3. They sell a proportional part under the same terms
  4. If the buyer won't purchase from minorities - the entire deal may be canceled

Restrictions on Share Transfers

In addition to Drag and Tag Along rights, the agreement should include restrictions on share transfers:

These restrictions ensure that shares don't fall into unwanted hands and that current shareholders get first opportunity to purchase.

Handling Sales to Institutional Investors

When the company raises investment from institutional investors (VCs, funds), the agreement should address the new situation:

Usually a new agreement is signed including the new investors, but it's important to establish from the founders stage how to handle these developments.

Employment Obligations, Non-Compete Commitments and Activity Restrictions

Startup founders are not just shareholders - they're also the company's most important employees. The agreement should clearly regulate their employment obligations, non-compete commitments, and what happens when a founder wants to work on other projects simultaneously.

Full-Time Work Commitment

Most investors will insist that founders commit to full-time work. The agreement should define:

It's worth allowing certain activities that don't compete with the company, such as conference speaking, limited professional consulting, or academic activity. This allows founders to maintain professional networks and bring new knowledge to the company.

Non-Compete Obligations

In Israel, the Employment Contracts Law, 5730-1970 and the Restrictive Trade Practices Law, 5748-1988 limit non-compete obligations. Courts tend to ensure that obligations are reasonable in scope and duration.

Principles for reasonable obligations:

Prohibition on Soliciting Employees and Customers

Beyond direct non-compete, the agreement should prohibit:

These restrictions are usually easier to enforce than general non-compete, and courts view favorably prohibitions on direct harm to existing business.

Confidentiality and Trade Secrets

Founders are exposed to the company's most critical information. The agreement must include:

It's important to distinguish between trade secrets (protected forever) and general professional knowledge acquired by the founder (which cannot be restricted).

Intellectual Property and Developments

All development, invention, or idea that a founder develops within their work should belong to the company:

Founders should sign intellectual property assignments both as shareholders and as employees, to ensure rights truly transfer to the company.

Financial Management, Investment Reception and Financial Control Mechanisms

A successful startup will need external investment, and the founders agreement should be prepared for this reality. Additionally, it's important to establish upfront how to manage company funds, make budgetary decisions, and handle financial conflicts of interest.

Preparing for Funding Rounds

When the company raises investment, the shareholding structure changes drastically. The agreement should prepare for this situation:

It's important that all founders understand that raising investment means giving up control over some decisions. The agreement can establish decisions that cannot be changed without founders' consent (e.g., material change in technological direction).

Signatures and Financial Controls

Who has authority to bind the company, and for what amounts?

Example of authority levels:

It's worth allowing certain activities that don't compete with the company, such as conference speaking, limited professional consulting, or academic activity. This allows founders to maintain professional networks and bring new knowledge to the company.

Personal Investments and Loans

In early stages, founders sometimes lend money to the company or invest their personal funds. The agreement should regulate:

Founder Compensation

How and when do founders receive compensation?

It's important to remember that investors want to see founders who are "hungry" and motivated primarily by company success, not high salaries.

Reporting and Financial Transparency

Every founder is entitled to access the company's financial information:

Financial transparency prevents suspicion and enables informed decision-making. It's also essential for preparing for funding rounds, when investors demand accurate data.

Intellectual Property Protection, Rights Assignments and Intangible Asset Management

For most technology startups, intellectual property is the most valuable asset. Source code, algorithms, databases, brand names, and technological know-how - all these can be worth far more than the company's physical equipment. The agreement should ensure that all intellectual property belongs to the company and is properly protected.

IP Assignment from Founders

One of the most common problems: a founder developed technology before establishing the company. Who owns the technology?

The Patent Law, 5727-1967 and Copyright Law, 5768-2007 establish that rights generally belong to the original developer. Therefore it's crucial that the agreement includes:

Example: A founder developed a machine learning algorithm at university. They must check if the university claims rights (most Israeli universities do claim rights), and arrange licensing or rights transfer to the company.

Future Developments and Shared Code

All development done within the company framework should belong to it:

Rule of thumb: If development could benefit the company or harm it, it probably belongs to the company.

Trademark and Brand Protection

Company name, logo, product names, and slogans are important assets:

Under the Trademarks Law, 5732-1972, trademark registration in Israel provides protection for seven years (renewable). It's important to register not only in Israel but also in relevant markets (US, Europe).

Copyright Management in Code

Source code is the heart of most startup technology:

It's important to ensure that every developer (employee, contractor, or founder) signs an assignment agreement transferring copyright to the company.

Patents and Inventions

Should a startup company register patents? It depends on the field and strategy:

If deciding on patents:

Non-Disclosure Agreements with External Parties

When presenting technology to investors, customers, or potential partners:

Not every party will agree to sign an NDA (e.g., leading VCs), so it's important to decide upfront what can be shared without legal protection.

Exit Strategies, Company Dissolution and Asset Distribution

Not every startup succeeds, and not every partnership lasts forever. The agreement should prepare for various ending scenarios: successful company sale, dissolution due to business failure, or dissolution due to conflicts between founders. Proper planning upfront can save a lot of money, time, and stress.

Successful Exit Scenarios

When things go well, the goal is to maximize returns for all shareholders:

In any such scenario, the Drag Along and Tag Along rights we described earlier come into play. It's important to understand the proceeds distribution:

  1. Loan repayment: Repayment of shareholder loans
  2. Preferred shares: Institutional investors usually receive preference
  3. Proportional distribution: Remainder divided proportionally to common share holdings

Voluntary Dissolution Due to Business Failure

When the company isn't succeeding and there's no more money or hope, it's better to dissolve amicably:

An orderly dissolution process includes:

  1. Notice to employees and providing required advance notice under law
  2. Terminating contracts with customers and suppliers
  3. Ending leases and canceling services
  4. Liquidating inventory and assets
  5. Paying off debts
  6. Filing required documents with the Companies Registrar

Dissolution Due to Founder Conflict

This is the most difficult situation - the company might be successful, but founders can no longer work together:

The "shotgun clause" (described earlier) can resolve such situations. If that fails, sometimes the best decision is to give up the company and start over.

Rights and Obligations in Dissolution

The Companies Law establishes priority order in dissolution, but the agreement can modify some provisions:

  1. Debts to external creditors: Debts to banks, suppliers, employees
  2. Shareholder loans: Money founders lent to the company
  3. Preferred shares: Investors who received liquidation preferences
  4. Common shares: Remainder divided among founders according to holdings

It's important to remember that founders who signed personal guarantees (e.g., to bank or landlord) will still owe personally even after company dissolution.

IP Allocation in Dissolution

What happens to technology developed when dissolving the company?

The decision depends on technology value, founders' non-compete agreements, and investor positions (if any).

Tax Planning in Dissolution and Exit

Tax aspects can significantly affect net proceeds:

Professional tax advice is a smart investment in any successful exit scenario. The differences between tax types can be enormous.

Common Mistakes, Legal Pitfalls and Recommended Best Practices

Decades of experience advising startups teaches that the same mistakes repeat themselves. Some mistakes are technical-legal, some stem from lack of communication, and some from excessive optimism. Knowing common mistakes can save time, money, and future difficulties.

Mistake Number One: "We'll Sort It Out Later"

The most common mistake is postponing signing detailed founders agreements. Founders say: "We're good friends, we'll sort everything out when we succeed." The problem: when conflict or success arrives, it's much harder to agree.

Why this happens:

The solution: Agree on principles when the atmosphere is good, and formalize an agreement even if relatively simple. You can always update and elaborate later.

Mistake Two: "Feel-Based" Equity Division

"We're three founders, so 33% each" - sounds logical but isn't always fair. Equal division means all founders contribute equally, dedicate the same time, and take the same risk.

Examples of unfair division:

The solution: Calculate division based on expected contribution, not just number of founders.

Mistake Three: Vesting vs. "Full Ownership"

Founders sometimes think: "We're not employees, we're the owners - why vesting?" The answer: exactly because of that. If a founder leaves after 6 months and takes 25% of the company, it can destroy fundraising.

Common arguments against vesting and responses:

Vesting is standard worldwide. Without it, it's very difficult to raise professional investment.

Mistake Four: Ignoring Prior IP

A founder developed technology at a previous workplace, university, or side project - and forgets to check who owns the rights. This can blow up the company later.

Examples of common problems:

The solution: Careful legal review of all relevant intellectual property before establishing the company.

Mistake Five: Not Addressing Spouses/Families

Married founder - is the spouse a business partner legally? What happens in case of divorce? This isn't personal when millions are involved.

Important issues to regulate:

The Property Relations between Spouses Law, 5733-1973 can grant rights to a spouse even if they're not involved in the business.

Recommended Best Practices

How to do it right from the beginning:

  1. Start with a simple agreement: Better a basic agreement than no agreement
  2. Update according to developments: Investment rounds, hiring employees, direction changes - all justify updating the agreement
  3. Consult with experts: Lawyer, accountant, business advisor - they've seen it all
  4. Learn from others: Talk with other founders about their mistakes
  5. Think about worst-case scenarios: How to handle problems when they occur, not just when everything's good

Founders Agreement Checklist

Before signing, ensure the agreement includes:

A good founders agreement is insurance. You hope you won't need it, but when the situation arises - you'll be glad you have one.

The information contained in this article is general in nature and does not constitute legal advice. For advice tailored to the specific circumstances of your company, we invite you to contact our firm.

Adv. Or Elyashiv
Written by

Adv. Or Elyashiv

Founder of Or Elyashiv Law Firm, specializing in technology law, privacy protection, intellectual property, and commercial law. Advising tech companies, startups, and international investors.

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