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.

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 she wanted to spend more time with him 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. It matters a lot more than the names on the cap table when the company was founded but almost always happens when one or more of those names play key roles in the longer-term success of the business (success rates for comapanies where all founders depart in the first few years are abysmally low for all the reasons one might expect).

As such, it is reasonable to put a structure in place that requires the founding team to “earn” their 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 but did not contribute to the success? 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 happens to 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!