VCR
VENTURE CAPITAL REVIEW
ISSUE 22
WINTER 2009
P R O D U C E D B Y T H E N AT I O N A L V E N T U R E C A P I TA L A S S O C I AT I O N A N D E R N S T & Y O U N G L L P
National Venture Capital Association (NVCA)
The National Venture Capital Association (NVCA) represents more than 450 venture
capital and private equity organizations. NVCA’s mission is to foster the understanding
of the importance of venture capital to the vitality of the U.S. and global economies,
to stimulate the flow of equity capital to emerging growth companies by representing
the public policy interests of the venture capital and private equity communities at
all levels of government, to maintain high professional standards, facilitate networking
opportunities and to provide research data and professional development for its members.
National Venture Capital Association
1655 Fort Myer Drive
Suite 850
Arlington, VA 22209
Phone: 703.524.2549
Fax: 703.524.3940
Web site: www.nvca.org
To Buy or Not to Buy?
Giving Founders Early
Liquidity
BY
SARAH REED AND
PETER FUSCO
Founder cash-outs are no longer the sole province of
later-stage, private equity deals. With the economy in
a tailspin and a paucity of exit opportunities, some
founders may become vocal about requests for partial
liquidity in advance of an exit event that provides
liquidity for all equity holders. But the impetus for
a partial cash-out of a founder may also come from
investors – for example, investors seeking to deploy
more capital and get more ownership in a Web 2.0 deal,
where the company’s low cash burn makes it debatable
whether VC funding is needed at all. Some investors may
also favor letting a founder take some cash off the table
as a way of better aligning interests – either where the
investors feel the founder needs some financial cushion
to tide her over to the big exit that the investors
are looking for or sometimes, conversely, to check
excessively risk-taking behavior. As one investor put it:
“not all companies should be swinging for the fences.
There is a right outcome for every company; some
should just be trying to lay out a double.” There may
be other, pragmatic reasons for buying out some or all
of a founder’s position – as when a founder leaves the
company but retains a large equity stake and becomes
uncooperative or even hostile. In such cases, an early
repurchase (if the founder is willing) may afford the
proverbial ounce of prevention.
Some venture capitalists are hostile to the idea of
all such repurchases, regardless of the underlying
rationale. In particular, a founder’s “it’s the economy,
stupid” argument cuts both ways: investors may be less
sympathetic to such requests at a time when they are
advising all of their portfolio companies to hunker down
and conserve cash. Further, a request from a founder
to cash out some stock may signal to the investors
a palpable lack of confidence in the business. At the
other end of the spectrum, the Founder’s Fund has
burnished its reputation among entrepreneurs through
its public embrace of founder cash-outs by means of
its branded “Series FF” stock, a type of stock that is
pre-baked into a company’s charter from inception as a
vehicle for such cash-outs.
❉❉❉
Sarah Reed and Peter Fusco work in Lowenstein Sandler's
Tech Group, a nationally recognized thought leader in
the development of technology based and venture backed
businesses across industries. Prior to joining Lowenstein
Sandler, Reed was the General Counsel at Charles River
Ventures, a preeminent early-stage venture capital firm, and
prior to that she was General Counsel at a publicly-listed
tech company. Peter Fusco's practice concentrates on all
aspects of private equity transactions, including seed and
angel investments, traditional and corporate venture capital
investments, private placements, strategic partner investments
and related financing alternatives.
The only thing that can be said for certain is that most
investors have strongly held views on the subject of
founder cash-outs. Those views are typically driven
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by a combination of gut business instinct about the
wisdom of such repurchases and war stories, not all of
which may be first-hand. Efforts to provide founders
with early liquidity also raise a thicket of legal, tax
and accounting issues which should be considered
once the discussion has been entered. For those in the
“against” camp, take heart: sometimes those issues
may be sufficiently daunting so as to shut down the
discussion entirely. Those who are in favor need to be
sure to navigate these issues successfully so that what
they envision as a win – be it in the form of good PR
or more ownership for their firm, better alignment of
interests or neutralizing a potential opponent – does
not turn into a loss.
selling $1 million of common stock, the investors may
purchase an additional $1 million of preferred stock in
the financing round. The proceeds from the investment
then provide the necessary cushion to ensure that
the company is complying with the required statutory
financial metrics when effecting the repurchase of the
founder’s stock.
Socialize it with the syndicate
Even if you or your firm have reached the conclusion
on a particular set of facts that a founder repurchase
makes a lot of sense, there may be other investors
around the table who consider it nothing less than a
fundamental violation of their firm’s culture and core
values. Assume that the transaction will elicit strong
reactions among at least some of your co-investors,
and you will not be caught flat-footed. In order to
ensure harmony within the syndicate, it is important to
obtain buy-in from one’s co-investors (or, potential coinvestors, where you are proferring a term sheet) before
having any discussions with the founder-seller. You may
want to point out, for example, that by offering the
founder some liquidity now, you are forestalling what
otherwise is likely to be the inevitable “management
bonus plan,” which reduces the money available on exit
for all of the investors.
(The usual) Rule #1: Don’t break the law
It’s not just a bad idea for a not-yet-profitable or even
cash-flow-neutral start-up company to use its cash to
buy out a founder. It’s probably against the law. In
Delaware, where most venture-backed companies are
incorporated (and check for similar statutes in other
jurisdictions, if your portfolio company is incorporated
elsewhere), Section 160 of the Delaware General
Corporation Law (DGCL) prohibits companies from
repurchasing their outstanding capital stock unless they
can meet specified financial tests. Before authorizing
a repurchase, the board of directors needs to ensure
that the company will be able to meet its liabilities as
they mature following the repurchase. If the board of
directors undertakes a redemption (repurchase) without
satisfying this requirement, Section 174 of the DGCL
provides for joint and several personal liability of the
directors (a rarity under the DGCL). The purpose, of
course, is to create a strong disincentive for the board
of directors to effect “sweetheart” transactions with
insiders that would impair the company’s capital, to the
detriment of third party creditors.
Consider the impact on the common stock
option pricing
Founders, by definition, receive their stock early in
the company’s history, at a time when they typically
need to pay only pennies, or even a fraction of a cent,
per share. To make the buyback of any interest to
them, they have to sell their stock at well above their
initial purchase price – and usually above the current
exercise price for the company’s common stock options.
With IRS regulations (409A) and accounting standards
(FAS 123R) that significantly increase the risks and
penalties for getting it wrong, companies today must
be ever more vigilant about 1) granting common stock
options at (no less than) fair market value (FMV) and 2)
not doing anything that would call into question that
valuation. How then can a founder sell her common
stock for a price in excess of the current option strike
Where the transaction is one between a founder-seller
and investors, Section 160 is not implicated. However,
what the founder has to sell is typically common stock
– while what the investors want to own is preferred
stock. As a result, sometimes the investors will fund
the company’s repurchase, rather than standing in as
the buyer themselves. For example, if the founder is
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is whether the transaction takes place “within the
company” (where the company is the buyer and retires
the stock repurchased from the founder to treasury
stock) or “outside of the company” (directly between
investors and the founder-seller). “If the investor owns
over 10% of the company, the accounting rules treat
him as a related party, and there is a presumption
that transactions between related parties are not at
fair market value” – hence greatly diminishing the
risk that the auditors will view the transaction price
as dispositive of the common stock FMV. Further, as
this auditor pointed out, if the transaction takes place
outside of the company, it is not even necessarily
something the auditors will review (unlike an intramural
transaction, which will most definitely be reflected in
the company’s records): “bear in mind we audit the
company, not the founder.” Even so, this auditor was of
the view that a price set in a transaction between the
company and the founder would not be insurmountable
– it would simply carry much more weight when it comes
to valuing the company’s common stock, and would at
minimum require the company to hire an outside 409A
appraiser to support its common stock FMV.
price, without calling into question the company’s
pricing of its options?
It will not come as a great surprise to anyone who
has navigated even the edge of the 409A/FAS 123R
minefield that there is no clear consensus among (or
even within) 409A valuation firms and audit firms on
this topic. All of the 409A appraisers with whom we
spoke in connection with this article reported that
they are able to “get comfortable” with an analysis that
says that a founder sale at price in excess of current
appraised common stock FMV does not necessarily have
to result in an increase to FMV. Factors critical to their
reaching such a conclusion include: 1) the founder is
selling only a portion of her stock, not her entire stake;
2) the repurchase is a “one-off” transaction, and the
offer is not being extended to others (i.e., it is not part
of a broader tender offer); and 3) both buyer and seller
are company insiders, so it is not really an “arm’s length”
transaction. Further to the point that both parties are
insiders, the investors are often securing some type of
direct or indirect additional benefit in connection with
the repurchase – e.g., a release and indemnification
from the pariah-founder, a vote in favor of a financing
round, or extension of a non-compete. In such cases,
the company’s position that the purchase price for the
founder’s stock is not representative of the FMV of the
common stock may be buttressed by the fact that the
buyers are getting valuable consideration for their
money, above and beyond the stock itself.
The long and short of it is that, in any case where
a founder is selling common stock at a price above
the current option grant price, it is essential for
the company to discuss in advance with both its
independent 409A appraisal firm (if it has one) and its
auditor the impact that the transaction will have on its
common stock FMV going forward. Be prepared for the
fact that the appraisal firm and the auditors may have
different reactions: the way that FMV is determined in
order to qualify for the safe harbor under 409A is not
the same methodology used by the auditors, and can
in theory lead to different results. And it is important
to understand that the risks of “getting it wrong” are
different under 409A and FAS 123R. Under 409A, if the
IRS later determines that employees routinely received
stock grants at below FMV, they face individual,
non-trivial tax liability, leading at best to unhappy
employees and at worst to lawsuits. Under FAS 123R, if
the auditors conclude the company was underpricing its
stock grants, the delta between the grant price and the
“correct” price as determined by the auditors becomes
Yet, it is precisely the “non-arm’s length” nature of the
transaction that may lead at least some auditors to
reach precisely the opposite conclusion. A managing
partner at one of the Big Three audit firms, who works
closely with VCs and their portfolio companies, shared
a more skeptical view of such deals, saying: “How
can you discount the price set in a recent transaction
between probably the two most knowledgeable parties
in the company? You have to be intellectually honest.
The redemption of founder shares at a price higher than
that of the 409(A) FMV determination will reset the
common stock FMV, no way around it.” However, another
of his partners, on the other coast, took a more liberal
view and emphasized that, to him, what is most critical
25
a compensation charge taken against the company’s
earnings (which may not be a material risk for an earlystage start-up).
investor with first-hand relevant experience pointed
out, such lawyer’s language can’t protect against the
sense of rage and injustice that a founder-seller may
feel if the company actually does have a liquidity
event shortly thereafter, where the stock is sold for
a price well in excess of the price received by the
founder-seller. Should you want to provide for such
an eventuality in the stock purchase agreement, you
could consider including what investors call “schmuck
insurance” and lawyers call a “redface clause,” providing
that if the company is sold within some defined time
period following the transaction with the founder, and
the stock price in that transaction is greater than that
received by the founder, the founder will get some or
all of the difference.
Don’t surprise the seller
While the company will of course strive to keep its
common stock FMV low despite a purchase of a founder’s
common stock for a much higher price, the company’s
victory could be the founder’s defeat. If the founder sells
stock back to the company at, say, $2 per share, and
the 409A valuation and audit confirm a common stock
FMV of 50 cents a share, that could yield an income tax
liability for the founder on the $1.50 difference, with
the IRS taking the position that the company overpaid
because it was compensating the founders for rendering
services (and therefore the overpayment should trigger
tax at ordinary income rates).
In addition, some investors simply will not purchase
stock from a company insider without getting the usual
protections that one would see in an M&A deal, namely
representations and warranties (made personally by the
seller) as well as an escrow, should any of those reps
and warranties turn out to be false. In such a case, be
prepared for the fact that, if you are a new investor to
the company who is purchasing founder stock as part
of a financing round, the negotiation with the founderseller is very likely to quickly become a three-way one,
where the existing investors (who are not putting up
their own money for the repurchase and simply want
to get the deal done) take the side of the founders,
vouching for their credibility and arguing that such
“belts and suspenders” are unnecessary. Others take
what might be considered a more pragmatic approach
and never ask for such provisions, on the basis that
they are “not in the business of suing founders” and, if
they were, they would not be in the business at all for
much longer.
Check for applicable transfer restrictions
Where founders are selling stock, company and investor
counsel will also need to pay attention to any applicable
transfer restrictions on that stock and whether those
restrictions can be successfully navigated. For example,
most founder common stock is subject to a right of
first refusal (usually in favor of the company first,
and the investors second) and co-sale rights (of the
investors). It is obviously elemental first to ensure
that any parties with a right of first refusal and/or cosale rights will waive those rights as necessary – lest
everyone find they have spent a lot of time and money
with lawyers structuring a transaction that breaks
down at the end game because other investors want
to “pile on” to the sale and offer their own shares for
sale (by way of the co-sale right) or conversely wish to
insert themselves in a purchase transaction that has
been painstakingly negotiated between a founder and
a particular investor.
Last, if the transaction is directly between the founder
and an investor, where the investor is buying common
stock, the investor needs to be mindful that this
common stock does not come with all of the bells and
whistles of the investor’s preferred stock, and thus,
to the extent such additional rights are sought (e.g.,
having the additional common stock holdings count for
purposes of calculating preemptive rights), they will
have to be separately negotiated with the company.
Protect the purchaser
Any well-drafted stock purchase agreement will contain
the standard “eyes wide open” provisions stating that
the founder-seller is aware that the stock being sold
could appreciate greatly in value, the company could
be sold or go public and the seller is an insider with
detailed knowledge of the company. However, as one
26
Panaceas can be problematic, too
hands. Founders, though, have a number of reasons
There are at least a couple of purported “work arounds”
to the FMV-impact problem. None is a silver bullet.
to prefer a stock sale. First, their gain on the sale is
taxed at capital gains rates. Second, they either pay
market-rate interest on a loan or, if not, are taxed to
Series FF stock is designed to solve the pricing
problem at the outset: at the company’s inception,
the founders are issued a series of stock that, while it
looks and feels much like common stock at the time
of issuance, is designated as preferred stock. The only
special feature this Series FF stock has at the time of
issuance (that distinguishes it from common) is that
it can be converted into the new series of preferred
stock issued in a subsequent financing round and
purchased by the investors in that round. While it is
unusual for one series of preferred stock to be defined
by a future, indeterminate series of preferred, there is
a section of the DGCL, Section 151, that permits the
“rights, preferences and privileges” of a class of stock
to be determinable based upon information outside
the certificate of incorporation — provided, however,
that the manner in which such facts operate on the
rights and preferences are clearly and expressly stated
in the company’s charter. Although the case has never
been presented to the Delaware Chancery Court, sellers
of Series FF stock should be aware that there is at
least a theoretical risk that an unhappy investor could
later seek to challenge the transaction on the ground
that Section 151 cannot be read so expansively as to
create a class of stock the primary feature of which is
its convertibility into a class of stock that does not
even exist, with all rights, preferences and privileges
“TBD.” Auditors may also take a more cold-eyed view of
Series FF – is common stock that can magically morph
into preferred, for the sole purpose of letting the
founder-owner sell at price significantly higher than his
original acquisition price, anything more than legal and
accounting legerdemain? Aside from any technical (and
granted untested) legal and accounting objections to
Series FF, the simple fact is that it remains quite rare in
company charters. In the vast majority of cases where
the issue of a founder buyback arises downstream, it’s
not even an option.
the extent of the benefit received. Third, if the loan
itself ends up being forgiven, the founder is taxed on
the “forgiveness of indebtedness” (imputed) income.
Fourth, in order that the transaction be respected as a
true loan for tax purposes, it is prudent that the loan
be fully collateralized. This is most often accomplished
with a pledge of the founder’s common stock (based on
the current FMV of the pledged stock). However, where
a founder collateralizes the loan with her equity in the
company, there is a risk that the IRS will “look through”
the loan structure and characterize the arrangement
as a stock option, for tax purposes. If the founder can
walk away from the loan without any further recourse
personally to the founder when the value of the
collateral is worth less than the loan amount, the entire
arrangement starts to look similar to a stock option, in
that the founder can elect to repay the loan if the value
of the stock increases, or walk away from the loan (and
the stock) if the value of the stock decreases. In this
situation, an unsuspecting founder may become subject
to a tax in the event his repayment is deemed an option
exercise, and the entire arrangement could be subject
to Section 409A, and thus taxable on day one. Last,
loans to management team members have generally
fallen out of favor since the advent of Sarbanes-Oxley,
which prohibits loans to public-company executives and
hence requires any such loans to be repaid in full before
a company can go public.
Conclusion
Given the current state of the economy, founder requests
for partial liquidity may become more common. And for
the same reason, investors may be even more loathe
to accommodate them. We hope this article can help
investors be better prepared to respond to such requests,
by highlighting the important considerations to be taken
Others advocate loans to founders, once there is an
agreed-upon objective to get some cash into their
into account when faced with such a situation.
27
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