Why Institutional VCs Flag a Founder-Drafted Co-Founder Agreement

Institutional venture capitalists conduct legal due diligence on a co-founder agreement before they finalise a term sheet, not after. The document they find in most early-stage data rooms is a founder-drafted PDF, a downloaded template, or a two-page email chain converted into an agreement at incorporation. What a VC’s legal team does when they open that document is very different from what the founders imagined when they signed it. The flags they raise are specific, predictable, and correctable if you know what to look for before diligence begins.

Why does a VC’s legal team scrutinise a co-founder agreement specifically?

A VC’s legal team scrutinises the co-founder agreement because it is the earliest governance document in the company’s life and therefore the document most likely to carry structural defects forward. Ownership clarity, IP chain of title, vesting mechanics, and leaver provisions all originate here. If any of these are missing or ambiguous, they create cap table risk, IP ownership risk, or a scenario where a departed founder holds equity that cannot be bought back, each of which affects the investor’s post-investment position directly.

What a VC’s legal team actually checks in the data room

When an institutional VC’s legal counsel opens a co-founder agreement, the legal review has two purposes. First, it maps what the document says against what the Articles of Association (AoA) say. Second, it maps both against the actual cap table. Where these three diverge, the VC’s team raises a query or a condition. Where they conflict, the deal stalls.

The review is not a clause-by-clause redline of grammar. It is a risk-mapping exercise. Each identified gap is scored against one of three categories: governance risk (who controls decisions and when), cap table risk (who owns what and under which conditions), and IP risk (does the company own its own product). A single gap in any category can be a deal condition. Two gaps in the same category can kill the round.

The five documents a VC checks in parallel:

A founder-drafted agreement typically survives one or two of these checks. It rarely survives all five.

The seven specific flags institutional VCs raise

Flag 1: Vesting schedule missing or incorrectly structured

This is the most common red flag in Indian startup diligence. A standard institutional-grade vesting schedule runs four years with a one-year cliff. The cliff means zero equity vests until the founder has been active for twelve months, after which 25% vests at month twelve and the remainder vests monthly over the following three years.

Founder-drafted agreements routinely make one of three mistakes: they omit vesting entirely (all equity is issued upfront), they include vesting language but do not define the cliff, or they run a two-year schedule which a VC’s team treats as inadequate protection against early exit.

The VC’s concern here is not abstract. If a co-founder holding 40% equity exits at month eight with no vesting schedule in place, that 40% sits with a non-contributing shareholder for the remainder of the company’s life. The investor’s money then works to build value for someone who left before the product shipped. In structural terms, this is called dead equity, and it is the leading reason Indian seed-stage deals are restructured or repriced before close.

No vesting at all, or vesting from day one without a cliff, is treated as a cap table defect, not a documentation gap. The remediation after a round is announced is expensive: it requires a buyback (which triggers Section 77 and 68 of the Companies Act 2013), a valuation report, board approval, and shareholder consent. Done before a round, the corrective vesting deed costs a fraction of that.

Flag 2: Leaver provisions undefined or absent

Good leaver and bad leaver definitions determine what happens to a departing founder’s unvested equity. A good leaver (typically: death, permanent incapacity, or termination without cause) retains vested equity and receives fair market value for unvested shares. A bad leaver (typically: voluntary resignation, termination for cause, competitive activity) forfeits unvested equity and may be required to sell vested equity at par value or a pre-agreed discount.

Founder-drafted agreements almost never define these terms. They either say nothing about departure mechanics, or they use the phrase “in the event of exit” without specifying whether the equity is bought back, forfeited, or simply retained.

A VC’s team flags absent leaver provisions because without them, the company has no legal mechanism to recover unvested equity from a departing founder. If that founder later disputes the buy-back price, the matter goes to arbitration or civil court, and the investor’s money is frozen while the dispute runs. Founder-level cap table events in Indian startups have repeatedly demonstrated how a single departure without documented buy-back mechanics affects every other shareholder’s position and forces a structured buyback that consumes management bandwidth at the worst possible moment.

Flag 3: IP assignment clause missing pre-incorporation work

Every line of code, every algorithm, every customer list, every brand asset, and every design created by a founder before the company was incorporated is, by default, the personal property of the person who created it. The company owns it only if there is a written assignment.

Section 17 of the Copyright Act 1957 confirms that the author of a work is the first owner. An employer can own copyright in work created in the course of employment, but pre-incorporation work sits outside any employment relationship because the company did not yet exist.

Founder-drafted co-founder agreements typically omit the pre-incorporation assignment entirely, or include a generic IP clause that says “all IP belongs to the company” without specifying the assignment of work created before formation. A VC’s legal team will ask: when was the product built, when was the company incorporated, and is there a written assignment dated and executed after incorporation that transfers pre-incorporation IP? If the answer is no, the company technically does not own its core product.

The remediation after the fact is possible but attracts scrutiny. A retrospective IP assignment executed immediately before or after a term sheet is signed looks transactional. A VC’s team will ask whether the IP was genuinely at arm’s length or whether the assignment was made under duress of the investment. This delays closing and sometimes requires an independent valuation of the IP to satisfy the investor’s legal team.

Flag 4: Non-compete clause unenforceable under Section 27

Section 27 of the Indian Contract Act 1872 renders any agreement in restraint of trade void. Post-exit non-compete clauses of the type “the exiting founder may not work in a competing business for two years after departure” are void under Indian law to the extent they restrict a person’s ability to carry on their occupation.

Indian courts have taken varying positions on founder non-competes that are narrowly drafted (restricted to use of the company’s confidential information, not a blanket prohibition on competing). The safer approach is not a non-compete at all but a combination of a strong confidentiality clause (restricted to specific categories of information), a non-solicitation clause (restricted to named employees and clients), and a robust IP assignment clause that captures any development undertaken during the employment period.

Founder-drafted agreements frequently include broad post-exit non-competes lifted from US-format templates without adapting them to Indian law. A VC’s legal team flags these because: (a) the clause is void, so the protection the founders believe they have does not exist; and (b) a void clause signals that the document was not reviewed by Indian legal counsel, which raises doubt about the reliability of the rest of the document.

Flag 5: Agreement not mirrored in the Articles of Association

A co-founder agreement is a contract between the founders. It binds only the signatories. The Articles of Association (AoA), by contrast, binds the company and all shareholders by operation of Section 14 of the Companies Act 2013. This means that vesting schedules and share transfer restrictions written into the co-founder agreement but not reflected in the AoA are not enforceable against the company itself or against any future shareholder who was not a party to the original agreement.

This is the most technically complex flag but also one of the most consequential. A founder-drafted agreement will almost never mirror its share transfer restrictions (pre-emption rights, lock-ins, tag-along, drag-along) into the AoA, because drafting a conforming AoA amendment requires familiarity with Table F of the Companies Act 2013 and the mechanics of passing a special resolution. The founders assume the co-founder agreement covers them. It does not.

When a VC’s legal team finds that transfer restrictions exist in the co-founder agreement but not in the AoA, they flag it as a material governance defect. The company cannot enforce the restriction against a future transferee. The fix is a special resolution amending the AoA, which requires 75% shareholder approval, a board resolution, and an MGT-14 filing with the Ministry of Corporate Affairs (MCA) within 30 days of passing.

Flag 6: Deadlock mechanism absent in equal equity splits

A 50-50 equity split is commercially common and legally valid. It is also, without a deadlock mechanism, the structural equivalent of building a company with no brakes. When two 50% shareholders disagree on a fundamental matter and neither has a casting vote, the company is paralysed: no resolution can pass, no board decision is binding, and no strategic action can be taken.

Deadlock mechanisms include: (a) a pre-agreed escalation process (negotiate, then bring in a mediator, then invoke a defined tiebreaker); (b) a shotgun clause (either shareholder can name a price, and the other must buy or sell at that price); or (c) a swing vote held by an independent director or advisory board member.

Founder-drafted agreements on 50-50 splits almost never include any of these mechanisms. A VC’s team flags the absence because, from their perspective, a deadlock at board level immediately after investment could freeze the company and trigger a Section 241 petition under the Companies Act 2013 (oppression and mismanagement), which would freeze the investment and potentially result in court-appointed management. An investor’s equity is worth significantly less if the company it represents is being administered by a court-appointed arbitrator.

Flag 7: Stamp duty unpaid or inadequate

A co-founder agreement is an instrument within the meaning of the Indian Stamp Act 1899. It must be stamped before or at the time of execution. Unstamped or inadequately stamped agreements are inadmissible as evidence in any proceeding before a court or arbitrator (Section 35, Indian Stamp Act 1899).

Stamp duty rates vary by state. In Maharashtra, a co-founder agreement falls under Article 5(h) of Schedule I of the Maharashtra Stamp Act 1958 (Agreement or Memorandum of an Agreement relating to other matters). Rates have been updated periodically and should be verified against the current Schedule before execution.

A founder-drafted agreement is frequently signed on a 100-rupee stamp paper without checking whether the applicable stamp duty for the state of execution is higher. A VC’s team will check this because an unstamped agreement is not worth the paper it is printed on in an enforcement context. If a founder dispute arises post-investment and the agreement cannot be produced as evidence, the investor has no protection mechanism, even if the agreement itself was well-drafted.

Why a VC treats a founder-drafted agreement as a governance signal, not just a paperwork problem

The flags above are correctable. But a VC’s legal team does not simply add them to a conditions list and move on. A founder-drafted agreement with three or more of these gaps signals something broader: the founding team has not had legal review of their core governance documents. This raises a specific inference in an investor’s mind.

If the founders did not get legal review at formation, what other governance shortcuts were taken? Are employment contracts compliant? Is GST registration in order? Were the early-stage share allotments done at proper valuations? Was Form FC-GPR filed if any foreign shareholder participated in an early round?

Each gap in the co-founder agreement becomes a prompt for deeper diligence in areas the investor had not initially planned to investigate. A clean, professionally drafted co-founder agreement does the opposite: it signals that the founders are governance-mature, which compresses diligence timelines and reduces the number of conditions attached to the term sheet.

The commercial consequence is concrete. Deals where legal diligence surfaces material defects in the co-founder agreement take longer to close (adding 4 to 8 weeks to a typical timeline), attract more conditions, and sometimes result in a valuation haircut to account for the restructuring cost the investor expects to bear. Deals where the co-founder agreement is clean and AoA-aligned move faster, with fewer conditions, and with fewer redline cycles.

How these gaps interact with the shareholders’ agreement at the investment stage

When an investor comes in, they will negotiate a shareholders’ agreement (SHA). The SHA governs the relationship between the founders and the new investor. Where the co-founder agreement says one thing and the SHA says another, a conflict arises that must be resolved. The standard resolution clause says the SHA prevails over the co-founder agreement. This is fine where the SHA is more favourable to the founders than the co-founder agreement. It is a problem where the SHA overrides a protection the founders assumed they had.

Specifically, three co-founder agreement clauses are most likely to conflict with a VC-negotiated SHA:

Tag-along rights: If the co-founder agreement gives each founder a right to tag along on any sale, and the SHA gives the investor superior tag-along rights that squeeze the founders’ tag mechanics, the SHA provision wins under the prevailing clause.

Transfer restrictions: If the co-founder agreement imposes a six-year lock-in and the SHA provides a shorter lock with defined carve-outs for secondary transactions, the SHA provision displaces the agreement’s lock.

Decision-making thresholds: If the co-founder agreement requires unanimous founder consent for strategic decisions, and the SHA gives the investor a minority veto or board seat that effectively gives them a voice, the SHA mechanism will in practice override the co-founder agreement’s threshold.

Founders who did not have legal counsel at formation are often surprised at the investment stage when they discover that the protections they thought they had written into the co-founder agreement have been superseded. A well-drafted co-founder agreement anticipates the SHA and includes a clause that explicitly states that the founders will negotiate the SHA in good faith but that the co-founder agreement’s core protections (vesting schedule, IP assignment, leaver mechanics) shall survive and be incorporated into the SHA.

What to fix before the data room opens

Founders who identify these gaps have a clear remediation path. The sequence matters because some fixes require board and shareholder approval.

Step 1: Vesting correction deed. If the original agreement has no vesting or defective vesting, a corrective founders’ vesting deed can be executed with the consent of all founders. This deed retroactively establishes a vesting schedule and a buy-back mechanism. It does not require board approval but should be noted in board minutes. Cost: low. Timeline: one to two weeks.

Step 2: IP assignment deed. A standalone IP assignment deed, executed by each founder and signed by an authorised director on behalf of the company, assigns all pre-incorporation and post-incorporation IP to the company. The deed should identify categories of IP explicitly: code, databases, algorithms, designs, domain names, trade secrets, and pending patent applications. Cost: low. Timeline: one week.

Step 3: AoA amendment. This is the most time-consuming step because it requires a special resolution (75% of shareholders by value), a board resolution, and an MGT-14 filing with MCA within 30 days. The AoA should be amended to mirror: (a) transfer restrictions (pre-emption, tag-along, drag-along); (b) vesting schedule (share buyback right on departure before full vesting); (c) good leaver and bad leaver consequences. Timeline: three to five weeks including MCA processing.

Step 4: Stamp duty validation. Confirm the current stamp duty rate in the state of execution and, if the agreement was understamped, pay the deficient stamp duty with applicable penalty under Section 35 of the Indian Stamp Act 1899 (penalty is a maximum of ten times the deficient duty in most states). This does not require board action and can be done at any time.

Step 5: Non-compete replacement. Add a standalone confidentiality and non-solicitation agreement to replace any void post-exit non-compete. This is a bilateral agreement between each founder and the company, executed in the company’s name by a director.

The entire remediation can be completed in four to six weeks if the founders are aligned and there are no disagreements about the corrected terms. Attempting the same remediation after a term sheet is issued, with an investor’s lawyers watching, takes longer and costs more.

Common mistakes that delay or kill Indian startup due diligence rounds

Using a US or UK template without Indian law adaptation. US co-founder agreements assume at-will employment, which does not exist in Indian labour law. UK templates assume Companies Act 2006 mechanics. Neither maps cleanly to the Companies Act 2013 or the Indian Stamp Act 1899. Provisions that are standard in these jurisdictions, including at-will termination triggering full bad leaver consequences, post-exit non-competes of two or three years, and equity cliff language borrowed from US stock option terminology, are either void or unenforceable in India.

Treating the co-founder agreement as a one-time document. A co-founder agreement drafted at incorporation is not a static document. It should be reviewed at the first external funding round, when co-founders’ roles change materially, and when a co-founder exits. Founders who bring a 2021 agreement to a 2026 Series A raise without any updates are presenting a document that predates the co-founders’ actual roles, the product they built, and the equity they issued to advisors and early employees.

Signing before shares are issued. An agreement executed before shares are issued cannot include a vesting schedule that is retroactively applied to already-issued shares. Retroactive vesting requires consent from the founder whose shares are being subjected to buy-back rights, which is a negotiation even among co-founders who trust each other.

Skipping the independent legal review. A co-founder agreement reviewed only by one founder’s lawyer, or by a lawyer who is a friend and charges nothing, is not independent legal review. It is review by someone whose interest may not be to identify all the gaps that a VC’s legal team will later find. Independent review means a lawyer who acts for the company, not for either individual founder, and who has seen enough VC diligence to know what gets flagged.

Leaving the 50-50 deadlock unresolved. Equal splits feel fair at formation. They become a governance problem the moment the two founders have a meaningful disagreement, which, statistically, they will. Founders who draft their own 50-50 agreement almost never include a deadlock mechanism because discussing it feels antagonistic. A VC who reads a 50-50 agreement with no deadlock clause simply adds “deadlock resolution mechanism” as a condition to the term sheet, and the founders negotiate it under time pressure, with an investor in the room.

FAQs

Q: Does a co-founder agreement need to be registered with any government authority in India?
A: No registration with MCA or any other authority is required. However, it must be stamped under the applicable state Stamp Act at the time of execution. Unstamped or understamped agreements are inadmissible as evidence under Section 35 of the Indian Stamp Act 1899.

Q: What is the standard vesting schedule an institutional VC expects to see in India?
A: Four years total, with a one-year cliff. This means 25% vests at month twelve, and the remaining 75% vests monthly or quarterly over months thirteen to forty-eight. Some VCs accept three-year schedules for experienced founders, but four years is the institutional standard.

Q: Can vesting be added to a co-founder agreement after shares have already been issued?
A: Yes, but it requires a corrective vesting deed signed by all co-founders, and the buy-back right must be clearly documented. If a founder objects to the retroactive application, the process becomes a negotiation. Treelife recommends completing this before any external investor is in the picture.

Q: What is the consequence of not having an IP assignment clause for pre-incorporation work?
A: Under the Copyright Act 1957, the author of a work is the first owner. Work created before incorporation is personally owned by the creator. Without a written assignment, the company’s claim to that IP is legally contested. A retrospective assignment is possible but attracts scrutiny from a VC’s legal team regarding whether it was at arm’s length.

Q: Are post-exit non-compete clauses in co-founder agreements enforceable in India?
A: Generally not. Section 27 of the Indian Contract Act 1872 renders agreements in restraint of trade void. Indian courts have occasionally upheld narrowly drafted restrictions tied to protection of specific confidential information, but a blanket post-exit non-compete is unenforceable. The recommended alternative is a strong confidentiality clause paired with a non-solicitation clause.

Q: What is the difference between a co-founder agreement and a shareholders’ agreement (SHA)?
A: A co-founder agreement governs the relationship between founders inter se, typically executed at or before incorporation. An SHA governs the relationship between founders and investors, executed at the time of investment. The SHA almost always contains a prevailing clause stating it supersedes the co-founder agreement on any conflict. A well-drafted co-founder agreement anticipates the SHA and preserves core founder protections such as vesting and IP assignment within the SHA’s framework.

Q: How much does it cost to fix a defective co-founder agreement before a VC round?
A: It depends on the number of gaps. A corrective vesting deed and IP assignment deed can be completed for ₹25,000 to ₹50,000 in legal fees. An AoA amendment adds stamp duty and MCA filing costs (MGT-14), plus professional fees, bringing the total to approximately ₹75,000 to ₹1,50,000 depending on complexity and state-specific stamp duty rates. Attempting the same fixes during diligence, with an investor’s lawyers involved, typically costs three to five times more.

Q: Does the co-founder agreement need to align with the ESOP scheme if the company has one?
A: Yes. If founders have an ESOP pool, the co-founder agreement should clarify that ESOP grants to employees are separate from founders’ equity and are governed by the ESOP scheme under Section 62(1)(b) of the Companies Act 2013. Confusion between founder equity and ESOP grants is a common data room problem.

Q: What happens to the co-founder agreement if a co-founder exits before the first institutional round?
A: The exit mechanics depend entirely on what the co-founder agreement says about leaver provisions and buy-back rights. If the agreement is silent, the exiting co-founder retains whatever equity they hold, which may or may not be bought back by the remaining founder. Any equity retained by an exited co-founder becomes a line item in every future investor’s diligence conversation.

Q: What is FEMA’s relevance to a co-founder agreement if one founder is a foreign national or NRI?
A: If any co-founder is a foreign national or NRI, equity issued to them constitutes foreign direct investment under the Foreign Exchange Management Act (FEMA) 1999. The company must file Form FC-GPR with the Reserve Bank of India (RBI) within 30 days of share allotment under FEMA (Non-Debt Instruments) Rules 2019. A co-founder agreement that does not disclose the nationality of each founder and the applicable pricing rules creates a FEMA compliance gap that a VC’s legal team will flag separately from the document’s internal defects.

Q: Can a co-founder agreement override a company’s AoA?
A: No. The AoA binds the company and all shareholders by operation of Section 14 of the Companies Act 2013. A co-founder agreement is a contract between the signatories only. Where the two conflict, the AoA provision governs corporate actions. This is why transfer restrictions in a co-founder agreement that are not mirrored in the AoA are unenforceable against the company.

Q: Does Treelife see this issue more in certain sectors or cities?
A: The pattern is consistent across sectors and cities. Deep-tech and SaaS startups have a higher incidence of the IP assignment gap because the CTO often builds before incorporation. Consumer startups on 50-50 splits have a higher incidence of the missing deadlock mechanism. The AoA alignment gap is universal and is the most common issue in every mandate regardless of sector.

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Treelife Team | support@treelife.in

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