This post is the twentieth in a series giving practical advice to startups with respect to understanding and negotiating a venture capital term sheet.
In the prior nineteen posts, we provided an introduction to negotiation of the term sheet and discussed binding and non-binding provisions and discussed valuation, cap tables, and the price per share, dividends on preferred stock, liquidation preferences, the conversion rights and features of preferred stock, voting rights and investor protection provisions, anti-dilution provisions, anti-dilution carve-outs and “pay to play” provisions, redemption rights, registration rights, management and information rights, preemptive rights, drag-along rights, representations and warranties, rights of first refusal and co-sale, closing conditions and expenses, non-competition and non-solicitation agreements, non-disclosure and developments agreements, and board matters. In this post, we will discuss founders’ stock.
The NVCA model term sheet provides, in the section labeled “Other Matters,” that the founders’ ownership of their shares of company stock will be subject to the company’s right to buy a certain percentage of that stock back at cost. The buyback right is effective for a certain period of time after the closing of the venture capital transaction — twelve months is suggested — and then lapses in equal increments over a given period of time. The increments could be monthly, quarterly, or even annually.
Before a venture capital deal, of course, founders own their company stock outright. When founders incorporate a company, they generally contribute capital and/or services to the company and the company issues shares to them. They may acquire more shares from time to time in exchange for cash or services. The founders and other stockholders might enter into a stockholders’ agreement that restricts transfer of shares, but generally they own their shares absolutely.
When a venture capital investor enters the picture, however, that investor wants assurance that the founders will not take the VC money for the company and abandon ship. When the company has the right to buy back the founders’ stock for a certain period of time, the founders have an incentive to remain with the company and work toward its success until the right lapses. It is important to note that this mechanism does not apply only to stock issued after the closing of the venture capital transaction; it applies to the stock the founders already own.
The company’s buyback right means essentially that the founders’ stock vests, just as employee stock options vest. Employee stock options typically vest under a schedule where 25% vests after one year and the remainder vests monthly or quarterly over the next three years. Founders’ stock often vests on a different schedule. Because the founders in most cases have already contributed capital and/or services to the company and grown it to the point that it is ready for a venture capital deal, the investor will often not require 100% of their stock to be subject to the buyback right; 75% is common. In that case, 25% of the founders’ stock would be treated in effect as already fully vested. The remainder usually vests over three to four years. This period can be measured from the closing date or from the date the founder purchased the stock.
The company’s buyback right is triggered if a founder’s employment with the company ceases. This might be for any reason, for example whether the founder quits, is fired for cause, or is fired for no cause. Alternatively, it might be triggered only if the founder’s employment is terminated for any reason other than without cause.
The company buyback right is a standard item in a venture capital term sheet. At the term sheet stage, the points to worry about are the percentage that is exempt from vesting (or treated as if already vested) and the vesting schedule. The details will be hashed out when the transaction documents are prepared. The founders’ stock provisions are often contained in a stock restriction agreement. At that point, the founders might attempt to negotiate for full or partial accelerated vesting upon the occurrence of certain events, such as the founders quitting for certain reasons or being terminated without cause or the company being sold. The founders will also want to take note at that stage of the buyback price, which is often the price the founders paid for the shares being repurchased. Before the deal closes, founders will want to check with their tax advisers and consider any necessary elections to avoid paying taxes on the increase in the value of shares upon vesting before the company distributes any cash.
Although founders might think it unfair that stock they already own should be made subject to vesting in a financing, they should recognize that the buyback right benefits them too, protecting each founder in the situation that another founder leaves the company, as well as the other common stockholders generally, who will experience an increase in ownership percentage should the company actually purchase and retire any founder shares.
In the next post, we’ll discuss no shop provisions.
© 2015 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.