Agreement Structures for Co-Founder Stock Buyouts and Future Investor Attraction
When it comes to a co-founder wanting to buy out another partner’s equity to attract future investors, there are several agreement structures to consider. These structures not only ensure that the buyout process is fair but also protect both parties from potential risks. This article explores two primary methods: the option agreement and the loan agreement.
Option Agreement for Stock Buyout
The option agreement is a flexible solution that allows a company to purchase a co-founder’s stock at a pre-negotiated price. This method offers a fair compromise that balances the company’s immediate needs with the potential for future investments. The key to a successful option agreement is setting the price at a level that is high enough to attract future investors without deterring them. The agreement should also specify that the option will continue past the next funding round to maintain the flexibility needed for further negotiations.
Let's illustrate this with an example. Suppose a co-founder wants to sell their 1 million equity to the company. If the option is set at 1 million dollars, it implicitly values the company at 5 million dollars. This setup establishes a ceiling for the payout, not a floor. No one is likely to offer more than 1 million, but there is a chance that the company or investors might negotiate a lower price. For instance, the next investor might propose investing 2 million but only if the co-founder agrees to be bought out for 100,000 dollars, or if the option price is reduced to 500,000 dollars. Alternatively, the investor might seize the opportunity to buy out the entire share at a steep discount along with the new investment. After a couple of years and some success in fundraising, the company could also offer to buy the co-founder's shares for 100,000 dollars on a take-it-or-leave-it basis, knowing that the co-founder needs the money and risks not getting anything if the company fails.
Loan Agreement for Buyout
An alternative method is through a loan agreement. In this arrangement, the company agrees to pay the co-founder a set amount of money at a future date. However, it is crucial that the company has a legal expert who ensures that the loan is subordinated to the company's other debts. This ensures that the loan does not hinder the company's ability to raise further funds through bank financing or convertible notes.
Similar to the option agreement, the loan can also lead to underhanded offers. For example, the next investor might negotiate a lower loan repayment amount in exchange for an early buyout of the co-founder's shares. Additionally, the company might consider buying out the co-founder's equity at a lower price in a future round, regardless of the original loan terms.
Expectations and Realities in Stock Buyouts
Never expect to be paid at the next funding round or through first revenues if the payout price is too high. The company will require that money, and no rational investor would fund a company knowing that a significant portion of the capital would be allocated to buying back a former founder's equity. In most cases, both parties find a compromise that works for the present, often involving a nominal value for the stock or a short-term loan.
My experience has shown that a company and a departing co-founder often settle on a deal that is feasible for both parties. This might include a very small percentage of stock, even as low as 1-2 percent, or on a short-term loan. While this may seem minimal, it can be more satisfying and a better solution in the long run.