Consider Repurchase Rights for Founders Stock

You took the leap and founded a new business. You and your co-founders have purchased your shares, own them outright, and are ready to go. Then someone suggests you should make these shares subject to a Repurchase Right. Huh?

Why should you agree to tie the shares you got for starting the Company to a right of repurchase that goes away over time similar to how employee stock options vest over time? There are a several reasons to consider doing this. We’ll name a few, but will first explain Repurchase Rights.

Repurchase Rights Defined

In the context of shares of stock, a Repurchase Right is a term that provides a party (or parties), typically the Company that originally issued the shares, to repurchase those shares from the shareholder who owns them. Repurchase Rights for startup companies are often used with Common Stock, in particular Common Stock issued to the founders of the business when the Company is formed. The Repurchase Right usually has a time-based structure meaning that the right to repurchase shares from the founder will lapse over a pre-determined time period.

What are the differences between a Repurchase Right and Vesting?

(1) The shareholder owns the stock subject to a Repurchase Right. Options Holders do not have any rights to stock options that are unvested.

(2) A Repurchase Right gives the Company an “option” to buy shares back from the shareholder under certain circumstances (typically upon leaving the Company). The Company does not have to exercise this right, and it must repurchase the shares from the shareholder (usually for the initial price paid). Failure to take these actions results in the shareholder keeping the stock that was subject to repurchase. With options subject to vesting the Company does not have to take any action on the unvested portion of the option grant if an employee leaves or is fired. These options revert to the Company automatically.

With Stock Option Vesting, if you leave during the vesting period you forfeit the unvested portion of your option grant. With a Repurchase Right, if you leave during the repurchase period you do not immediately forfeit the shares still subject to repurchase. The Company must elect to repurchase these shares and pay you for them. Usually the amount paid is equal to the original purchase price, but there are situations where the repurchase price is tied to the current value of the shares. Given that it requires a Company to come out-of-pocket to repurchase the shares, there are scenarios where the Company will elect not to repurchase. Many Repurchase Rights provide the right to repurchase to multiple parties in a waterfall structure. Usually the Company has the Right of First Refusal to repurchase the shares, but if it declines, this right will often then shift to investors in the Company with the right shared between them. If none of the parties who have a right to repurchase elect to do so within a pre-defined period of time, the shareholder will retain the shares.

We have seen situations where the Company and investors allowed a Repurchase Right to expire even when the business was doing well. Two examples of this include one where a Founder who was asked to step out of the CEO role and agreed with the new CEO that it made sense for them to depart the business, which they did amicably, and another case where the executive’s spouse had health issues and he wanted to spend more time with her so resigned from the Company with about six months left on the Repurchase Right clock but the Company decided it was appropriate to allow the right to expire.

The decision on whether to exercise the Repurchase Right is usually made by the Board of Directors, although the process maybe defined in a voting agreement which could provide for a different process to decide this matter. There are several potential conflicts of interest with the Board to consider. First, the departing shareholder might have a board seat and would clearly be an “interested party” when it comes to the Repurchase Right. Second, if Investors have a secondary right to repurchase, they might want the Company to waive its right so they can exercise their own repurchase rights. Legal counsel can help structure the repurchase terms to minimize these conflicts.

So, why should you consider tying at least a portion of your founders equity to a Repurchase Right? There are several reasons to do so – we cover four of them below:

When do you “earn” your shares?

Did you earn your founders shares for being there when the company was started, or is it implied, along with your co-founders, that you will have earned these shares for the time and energy you put into working side-by-side to make the business successful? It is usually a combination of these.

Founders often put in a meaningful amount of time, effort and sometimes also money before they formally start a Company. This should be recognized as should the simple fact the founder came up with the idea and took the leap to found the Company. However, great ideas seldom result in valuable outcomes without a group of people first putting in a significant amount of effort to turn the idea into reality. This is especially true since many businesses are successful based on business models and strategies that are very different from what was first envisioned when the business was formed. Execution matters A LOT.

As such, it is reasonable to put a structure in place that requires the founding team to “earn” these shares over time based on their ongoing engagement with the business as it grows and evolves.

Early Founder Departures

Ask any number of founders who had a co-founder bail on them for the “safety” of a high paying job at some big corporation but owned their shares outright and decided to keep them, how they feel about vesting founders shares. When you make the business a success, is it really fair that this person shares in the spoils in a big way? Doubtful.

Setting up a repurchase right on founders shares helps ensure each founder has a clear incentive to stick with the business and help it succeed, and forces them to make a hard decision if a different opportunity arises that they want to pursue. It keeps you aligned and keeps everyone motivated. To the extent any of the founders was planning to only stick around for a short period of time, setting up a repurchase right will encourage an up front discussion about this at the outset, which in the long-run will be a good thing.

Get Aligned with Employees

You will invariably expect early employees to accept a vesting schedule for their shares. While there are good arguments for how your founders shares should be treated differently, you should also consider the employees point of view and be aligned with them.

Showing your employees the importance of earning equity by having the founders earn it too can create a better working environment where everyone is in the same boat together. We’ve seen too many founders get frustrated that an engineer who owns .01% of a Company (on a four year vesting schedule) and makes less in cash compensation than they could earn at a large enterprise wants to go home at night while the founder (who happensto own 25% of the company outright) pulls all nighters to make the business work. This disparity will always exist, so anything you can do to bridge the divide is a good thing.

You’ll probably have to do it eventually anyways

If you end up raising outside capital, especially from venture investors, it is likely you will be asked to sign up to a repurchase agreement for some portion of your shares. In other words, you’ll be asked (required) to give up some of the stock you own outright and put it at risk based on your ongoing involvement with the company.

When this moment arises, one of the main points of discussion will be how much credit you should get for ‘time served’ and as a result how much stock should remain owned outright and not subject to repurchase. If you set a repurchase agreement up when you start the Company, and the terms of this are within the range of reasonableness (explained below), there is a good chance the investors will stick with the plan you have in place. Safe to assume they will also look favorably on the fact you already took this step as it shows you and your co-founders have a long-term commitment to the business.

The Range of Reasonableness

So, lets say you agree it makes sense to set up a Repurchase Right on your founders shares.  What terms are fair to the founders, and what will pass muster with future investors?

We cannot say with certainty as every situation is different, but here are a few things we’d recommend considering:

(1)  Keep 6-18 months for yourself. Assuming a four year vesting period, and that you have not been operating the business for more than 12 months, plan to keep between 6 and 18 months, or 12.5% to 37.5%, of the equity outright, and subject the rest to a repurchase right. The 6-18 month range is up to you, but two factors that argue for 18 months (or more) include a long incubation period where you worked on the idea before forming the business and a prior track record of success.

(2)  Tie the remaining shares to a Repurchase Right over three to four years. We typically recommend having the repurchase right on the shares lapse over the number of months left in the typical 48 months vesting period after subtracting the months you keep outright.  So, if you keep 12 months (25%) outright, you’d have 36 months remaining. An easier method is to just pick a repurchase period of three or four years (yes, the vast majority of founders select three years – go figure!). Three years is usually within the reasonable range that would be acceptable to investors.

(3) Protect Yourself – While we wish it were not the case, there are investors out there who will try to screw you over and you need to protect yourself. In terms of repurchase rights you should make sure you are protected from a scenario where the investors try to push you out of the business during the repurchase period in order to get some of your shares back into the Company (or worse, into their own hands). There are valid situations where investors want a founder to leave, but also those where the tipping point in the decision is the opportunity to pull back a bunch of stock from the founder. You should put a termination clause in the repurchase right that says if you are dismissed (fired) from the business without cause, that the repurchase right for at least some portion of the shares tied up will go away. If you leave on your own volition, the repurchase right stays in place, but if you are let go, the right goes away. If it is time for a founder to leave the business, having this structure in place will force the investors to work out an acceptable arrangement. Note the “without cause” statement – if you start to take actions detrimental to the business in an effort to get fired, you risk triggering a “for cause” determination which will nullify your protections. It is a reasonable structure as it helps ensure you don’t do bad things to get fired and keep your stock, while ensuring the investors do not fire you simply (or mainly) to get a bunch of your shares back.

(4)  Set up Change of Control protections. Item #3 protects you prior to the sale of the business, but after the Company is acquired you are dealing with a totally different set of decision makers. Ensure that all of the shares subject to repurchase have accelerated vesting for a change of control. We recommend a 100% Double Trigger which essentially means that if your business is acquired, and you are subsequently fired, forced to move outside of your current metro area, have your salary materially reduced, or have a significant change in your work responsibilities, the repurchase right ends and you own the shares outright. There is an arguement for a Single Trigger (repurchase right ends at change of control), but it does not usually pass the sniff test because part of the value in the acquisition is buying the team, including you. Look for another post that discusses Triggers (single and double) in more detail soon.

(5) Assuming you have good corporate counsel, discuss this with them to get their input on what terms you should consider in setting up the repurchase right. They should have some boilerplate terms from other deals that they can provide.

So, are you convinced that applying a Repurchase Right to founders shares is a good idea? If not, PLEASE include a comment to tell us why. If you are unsure, let us know what questions/concerns you have. If you have other reasons to consider having, or not having repurchase rights, please include these as well. If you found the article helpful, please comment to let us know (we like getting feedback), and please share it with others on Twitter, Facebook or a link from your website/blog.  Thanks!

About CapGenius
All about equity

22 Responses to Consider Repurchase Rights for Founders Stock

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  5. Great Article. I’ll be sharing with my startup clients when I get pushback on this. Thanks.

    • CapGenius says:

      Thanks, much appreciated. Hope it helps when you get pushback from clients. This brings up a point we want to share – Entrepreneurs should hire an attorney who will push back and give them feedback when the structure they want may not be in their best interests over the long run. Don’t hire someone to generate documents – hire someone who understands the importance of what goes into those documents.

  6. righteously indignant says:

    What if they were instrumental in setting up and keeping the company, missing ridiculous deadlines with barely-legal workloads, were the go-to person who knew and did everything that no one else would do, and were the company’s backbone and excyclopedic repository of knowledge and skills, all for six long years, and they left because they were being bled like a stone for more and more work and hours without fair compensation, weren’t listened to when their concerns that the company was being run into the ground (and how to fix them) fell on deaf ears, and were stressed to the brink of mental and physical illness and were hospitalized more than once because of it? Not to mention they accepted significantly lower pay than is average for their position for those six years in exchange for those stocks? Are they still the b**** who is profiting for no work, then? In such a case, I think the company is the one profiting unfairly off the blood, sweat and tears of their fellow founder and punishing them for leaving, since the company is in trouble without them and the co-founder knows it. I think my spouse (the above real-life example) is getting the better deal because I predict that without another financial transfusion from the remaining founder (the only one of four original members left now) that inside of two-three years the company is going to go under (they have no exit strategy, and are blind to their leadership deficiencies) and we will have gotten a deal, getting our money back and they will be left holding the very empty bag.

    • CapGenius says:

      Dear Righteous:

      Wow. Where to begin?

      Two things we can really comment on here given we don’t know the exact situation (and it sounds like we don’t want to):

      (1) Sorry – sounds like a terrible situation to be in. Choosing your co-founders wisely is probably the most important thing you can do and no vesting structure can save you from an untenable situation. Unfortunately, even situations where people think they have done this can go wrong.
      (2) The founder vesting we have proposed would not have been an issue for your wife given her six years of service to the company. There are clearly situations where co-founders can make things so miserable that you’d rather leave early than keep on vesting, but those are not common, and you can generally assume the end result will be a negative one for those co-founders anyways, as it sounds like it was in this situation. People who behave this way don’t often find great success (yes, there are frustrating exceptions).

  7. entrepreneur says:

    Is it possible to establish repurchase rights after the founders stock has been issued? (e.g. we issued the stock two months ago and are still laying the foundation for the company. There are several individuals who have not contributed except for several days as we began.)

    • CapGenius says:

      Todd:

      You can add repurchase rights at any time but will have to get agreement from the shareholder to assign these rights if they were not part of the initial structure (you actually have to get them to agree to this even if it is, but in that case if they refuse you can just decide to not give them any stock). Hopefully this will be possible for you. If not you might want to consider negotiating an arrangement with them that is fair given the short period of time they helped out. Realize that their idea of “fair” is likely to be different from yours and you should think about how to recognize their help in terms of things they helped you accomplish instead of days they worked (safe bet they will think of it this way).

      There are more “draconian” approaches if they refuse and if the remaining founders feel strongly that it is an unfair situation. All involve legal efforts and cost as you might expect. If you have to go down this route you should do it now while the company is still in the formative stages instead of waiting until later on. Ping us if this is the route you have to go and we will try to give at least some high level guidance and ideas you could explore with your legal counsel to see if they are feasible in your situation.

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  9. bob says:

    Can a company have an indefinite repurchase right (i.e. it does not expire no longer how long after the person leaves)? Does the law provide a default amount of time after which if expires, if no time limit is specified?

    • CapGenius says:

      Bob:

      Not sure if it is legally possible to have an indefinite repurchase right, but we have never seen this done before. The simple reason is that you should try to have some finality around the departure of a founder/employee, and setting an indefinite repurchase period would leave both sides in limbo for a long time. In fairness to the person who has departed, for the Company to wait for a long time (ie years) before deciding whether to repurchase the shares would make it possible to wait to know whether the business will be a success or not before making the decision to repurchase.

      That said, if the concern you have is that the Company might not have the capital available for the repurchase, you could structure the arrangement so that the Company declares its intention to repurchase but has some longer time period within which to pay for these shares. Alternatively you could structure the repurchase so the company has to decide whether to exercise its rights soon after the departure, but instead of paying cash for the shares would issue a debt instrument to the shareholder in question that would not be payable until some future date, which could be a future financing round or an exit (sale or IPO).

      To the best of our knowledge there is not “default” time period for expiration as there is no law specifically for repurchase rights – these rights are unique for each situation and tied to a legal agreement.

      If there is a specific scenario you are trying to plan for or avoid, please let us know and we’ll try to be more specific to your particular situation.

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  11. LostinLegalLand says:

    Question on a clause in stock agreement about Right to Repurchase. This clause states my company has the right to repurchase my shares within a set period of time. How is the price of the shares determined? Who sets that price? Also, do I have to sell? Can I refuse? What if I the company is repurchasing my shares so they can regain those shares and later the company has an IPO? To me that seems unfair. I feel like I am being bought out.

    • CapGenius says:

      Typically the repurchase right is set up so that if you leave the company they have the right to repurchase the stock from you. This may be tied to a stock grant with a repurchase right, or could be applied to a stock option, either one with early exercise rights, or one that has vested and been exercised. If the former it is pretty standard stuff. If it is tied to options you have early-exercised (meaning you have not vested/earned the shares, but you can exercise the options before this happens, sometimes available to employees for tax planning reasons). However, if it is the final one (vested and exercised stock options) we would have concerns about the approach this company is taking in granting equity to employees, namely that they are setting it up to make it possible to screw people over down the road.

      More on that below but first quick answers to the rest of your questions:
      How is Price Determined? It should be pretty clearly outlined in the document and if it is not you should not be afraid to ask. Typically this will be set at the price you paid for the stock (price per share), but if this is a situation where the company is putting in a repurchase right for vested and exercised options it might be set at the then fair market value. This is uncommon, and is better for you as the employee (which is why it is uncommon). Determining fair market value is a whole ‘nother can of worms (and is now in the article queue).

      Do I have to Sell? Can I refuse? Highly unlikely that you can refuse. If you could the whole point of the “Right to Repurchase” would be pointless, or at least not a “Right”

      What if they company is repurchasing my shares so they can regain the shares and later the company has an IPO? And herein lies the issue with Repurchase Rights IF those rights are tied to vested and exercised options. If this is a repurchase right on a share grant that you have to earn over time, and you have not met that time period requirement, it is hard to complain if they take these back. But if you actually “own” those shares and earned them, a clause giving them the right to buy them back kinda sucks….

      Specifically, if you have a stock option that has fully vested, and you exercised this option and now own the stock (purchased with your hard earned cash), and the company has a right to repurchase the stock, whether for a specific reason (you leave the company) or more generally, this is a bad situation and you should think twice about joining the company. The reason we say this is that if they are sticking these clauses in the stock plan for employees, they are doing so because they want to have the flexibility to potentially screw people over later. They will not say this of course, they will say they want to ensure they control the ownership and have flexibility, and that they “would never” do something to screw over employees. Unfortunately, history has shown that this is not always how things work out, and some combination of greed, weak morals and bad ethics come into play and when those shares of stock that have little value today are later on worth millions, people show their true colors. If the wrong person has the ability to leverage the repurchase right described above, you are at risk.

      Some will argue this clause is fair with employees who leave, to which we say, Bah! If the person earned (vested in) the equity, its done, they earned it, finished. There should not be a way to take this back at that point and a company who gives itself this ability is not doing it with their employees best interests at heart.

      hope this helped.

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  13. rhoneyman says:

    I have a somewhat different problem. There are four co-founders and a number of other shareholders. A potential lender is going to require personal guarantees for any shareholder exceeding 10% equity interest. Two of the co-founders are unwilling to offer a personal guarantee.

    The two who are willing will be issued new shares as compensation. The shares will have a vesting period. No problem here. However, the unwilling co-founders both need to have their current ownership interest reduced significantly.

    A repurchase arrangement (which is already included in employee agreements) doesn’t look like it addresses the ownership question cleanly enough. Instead, I was thinking of the unwilling co-founders remit shares to the corporation for safe-keeping and somehow weakening their ownership interest. That interest would be ceded back to the shareholder via a vesting mechanism.

    Does this sound plausible and feasible? Is there a better/more appropriate/more elegant way of accomplishing this?

    • CapGenius says:

      Picture flashing red lights and klaxons going off with ‘WARNING WARNING WARNING’, or in this case ‘AVOID AVOID AVOID’. Now read on…..

      Before we “answer” this question we are going to cover a lot of other stuff below, and then ultimately refuse to directly answer this question because based on what we read we (and I took a poll before writing this), all ADAMANTLY agree that you should not try to force a co-founder to personally guarantee debt for the business, that it truly runs counter to the reasons people form corporations and take personal risk starting companies, and that each of us would aggressively pursue legal action if we were in a situation where people tried to force this on us. (by the way, we also don’t think you should do it yourself, but more on that below).

      That said, we will suggest a potential alternative that would be fair to all parties.

      So, to continue, this is an interesting challenge, and frankly a new on for us. As stated above, we are violently opposed to the idea that equity holders should be required to provide personal guarantees on debt for a start-up. This is what is wrong with most of the lenders who claim to work with start-ups – they cannot get comfortable with the risk so do things like require you to guarantee the debt personally, charge absurd rates, or set it up so you can borrow the money but once your bank balance equals the amount they lent to you they prevent you from accessing the capital so there is no real point in having the loan in the first place (yes, this happens VERY FREQUENTLY). So, before instead of addressing your specific question, we’ll try to dissuade you from taking debt from this lender.

      One of the great things about being an equity holder (whether it comes from founder or working at a company or investing) is that your liability is limited (in standard cases) to what you’ve put into the company. You are taking a massive risk on a start-up in this regard, but you know your downside is limited to what you have committed to the business, personally and/or financially.

      Then along come these debt guys. They do not understand start-ups, they will never admit it but they cannot comprehend why you would take this sort of risk, and no matter what they tell you, they have no idea how to assess the creditworthiness of a business that has no revenue (or if already rolling has a negative cash flow). The number of lenders that truly understand these companies, are comfortable with this risk, and have been consistently focused on lending to start-ups can be counted on one hand. Everyone else is outside their comfort zone, so they end up asking for things like personal guarantees on the debt. Which leads us to START UP AXIOM #1:

      If someone ever requires you to personally guarantee money they are providing to a start-up, whether it is equity, debt or revenue, you should only accept this if they agree that you get to personally keep all of the gains related to their involvement. Why should you pay a lender above market interest rates and give them warrants (or other equity) in your company if you have to personally guarantee they’ll get their money back. Their risk is no longer tied to the business, it is now tied to you, so why should they get any benefits or upside from the company? Answer, they SHOULD NOT.

      Now, to try and get to your question, but with some more advice along the way:

      We do not believe equity holders should ever be required to guarantee debt, and unless this was clearly outlined in the documents they signed when they received the equity, it will be very hard to force them to make personal guarantees on behalf of the company, and frankly we think it is inappropriate to do so. Think about it this way – you join a company and agree you are going to work really hard to make it a success. You take a huge risk with your career and maybe put some money in to make it work. You have some money saved up which makes it possible to take this risk, and maybe you are married with kids and having something in reserve was a clear necessity if you wanted to give this start-up thing a shot. Now, AFTER you take that leap and start working to make the company a success you find out that you have to personally guarantee debt for the company. That sucks.

      Our advice would be that given the circumstances described you sound like you may have some founder conflict issues that need to be resolved, and that the debt guarantee issue has helped surface. You should think about whether this is accurate and if so work to resolve those before you deal with the specific debt issue.

      Next (whether we are right or wrong about broader conflict issues) – is this the only source of capital for the business? If so you should talk about why this is the case, and whether there are alternatives that are better than what is on the table (a debt guarantee sucks, trust us. Don’t forget these will be joint and several, meaning that each person is individually on the hook for all of the debt, so that if the other people who provided guarantees do not pay, you might have to, or worse, the lender may just go after one person because they have deeper pockets).

      Finally – a better solution. If the lender is focused on your personal assets for guarantees, have the two founders wiling to take on this risk just structure the loans to be personal loans, and then have these founders lend the money to the company, or invest it in the form of preferred equity where you get this money out first. As an individual you are taking on the same risk as with the personal guarantee, but instead of passing the upside for lending to the start-up to the lender, you are getting the “compensation” for backing this money up. You can structure it under the same terms as the lender was asking for, with all of that accruing to the two founders who are extending the loan. If you are reading this and thinking “I don’t want to personally loan money to the company” then stop now, call the lender and tell them you are going to pass because if you guarantee the loan you are in many ways doing exactly that, but with no upside because the only reason the company will fail to pay the debt is if it cannot do so, so if you get stuck with the debt on the personal guarantee it is a pretty safe bet you are sitting on a worthless company as well. Again, that sucks.

      As we said up front – AVOID AVOID AVOID.

      PS As an aside, one of our contributors shared a story about a lender who was setting up a $1 million line of credit for one of his companies. They got to the final paperwork when the lender threw in a clause that they wanted the venture investors to have their firms guarantee the debt. As any legit firm would do, the firms both refused and the company set up the line of credit elsewhere. The beauty of this story? Three months later, before the company drew down a nickel from the line of credit, they were acquired for $485 million. The warrants that the initial lender would have gotten (and the second one DID get) were worth over $1 million. Given the company never borrowed any money, the ‘debt returns’ for this lender included $500 paid in to exercise the warrants (yes, $500), and $1.05 million paid out a couple of weeks later. The second lender (one of the ones on our single hand above) reaped a return on investment that to this day continues to be a record in terms of IRR (Internal Rate of Return). They deserved every penny for stepping up.

      • rhoneyman says:

        Thanks, Cap. I agree completely with your response in the case where the lender is a non-government entity. However (I probably should have mentioned this), the lender in question is state government economic development agency. As we started getting into it after my initial post, we discovered that are some state grants associated with the whole package.

        Does that information change your assessment? Thanks again.

      • CapGenius says:

        It changes things in that I no longer question the motivation of the lender, but to be honest I’d be very concerned about having to guarantee a government loan of this sort. Grants are great, and usually require no financial guarantees. Just to understand, if they loan you the money and the business fails, they want you to repay them? If the answer is yes, then the initial response pretty much stands.

  14. Mark says:

    How would you deal with a vesting scenario if both founders will work on it besides their day job as we don’t have money or investors. I believe that I will be spending more time on it and have also thought of and created the first version of the product. So I was thinking about a 60/40 split.

    What is better? Get all stocks but have Repurchase Right. I am guessing that we would value the stocks rather low so repurchase costs would be low. Or have a vesting scenario that after a year your get 25% and from then 2% each month. Now difficulty here is of-course that for both of us it is not the full time job. (unfortunately).

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