Jun 2 2014, 5:00pm CDT | by Forbes
From time to time founders approach the board and investors of a private company and ask to sell stock*. Often this happens when the company is raising money, and the founders want to “sell into the financing”. Sometimes it takes the form of an isolated, direct deal between a founder and an investor.
I appreciate that founders have personal lives, wives, and families, and they need to pay for houses, cars, vacations, and college educations. They’ve often been at it for years before investors come on the scene, and they see the enormous progress that has been made from day one, even if there is also a long way to go.
Still, the founders and key executives play a special role in a small company: they embody the promise of the company and the drive to make it succeed. When I am an investor, I like it when a founder works to preserve every tenth of a percentage point of equity ownership: it reassures me that our stock is valuable, and that s/he is fighting every day to make it more valuable. By the same token, it’s a bit unsettling when a founder wants to sell.
In its early stages, a company often has limited access to capital. Operating cash flow is usually deeply negative. The investors at the table can put in only a certain amount of money, and a new investor may not step up on reasonable terms until the company achieves key milestones. At this stage, founders taking money out put the company at added risk of running out of money prematurely and needing to raise capital with its back against the wall. In the worst case this can lead to a distress sale or shut down.
Then there is the question of pricing the shares. Early-stage companies mostly sell preferred shares to investors, and founders mostly hold common shares that they acquired at a very low price when the company was formed. Usually there have been no transactions in these common shares, so there is no market pricing information. Companies often hire valuation consultants to do a “409a” valuation of common shares**. 409a valuations are done to facilitate the award of incentive stock options (ISOs) to employees: the lower the price can be, the better. Valuation is always subjective, and 409a valuation consultants know that they are hired to provide the lowest valuation of common shares that can be justified.
So, the 409a valuation price is probably less than an investor would be willing to pay. Trading common shares at the preferred share price, as founders sometimes suggest, is not good either: preferred shares have superior economic and governance rights to common shares; for that reason they are worth more. The right answer is in between, and where it lies between the preferred share price and the 409a valuation of common shares, which is often 20% of the preferred price, is not obvious.
Also, sale of common shares at a price above the 409a valuation undermines the credibility of the 409a valuation. So the next 409a valuation will take this new price into account, and future incentive options issued to employees will need to have higher striking prices, which reduces their value as a performance incentive.
Founders sometimes ask that the company buy back their shares. When a financing is about to occur and money is coming in, “selling into the financing” (selling shares to the company which are paid for with money raised in the financing) is quick and easy way for founders to achieve liquidity. It takes cash off of the company’s balance sheet, however. And a purchase of stock by the company from a key employee makes the Board of Directors responsible for determining valuation, however. Typically the Board consists of one or two founders, a few outside investors, and one or two others. Usually, the founders selected several of the other directors. Asking the board to set the price can create a difficult conflict of interest.
Here’s where we as a partnership have come to on this issue:
• We’re not excited about founders selling shares. We’d prefer that everyone keep his or her money in the pot and share together in the liquidity event towards which we are all working. And, we’ve found that when founders cash out a large percentage of their equity, they often check out, too. So the request to sell can be a sign that new management will soon be needed.
• However, if the company has reached the point at which its future access to financing has only moderate risk, and if the founders feel strongly they need some liquidity, we can support sale of a small fraction of founder shares. Moderate risk means that the company is able to fund its essential ongoing needs with internally generated cash flow (or close to that point), and it is doing well against its plans and goals, and hence likely to be able to raise outside capital if needed.
• We push hard for the common shares to be sold directly to an investor at a negotiated price. This provides a “skin-in-the-game” valuation. And it makes it more likely that the money paid for the common shares is incremental money, rather than a diversion of funds that would otherwise be available to the company.
*Many small companies with outside investors have agreements that prohibit one shareholder from selling stock without the agreement of the board and a super-majority of the other shareholders.
**The name refers to Section 409(a) of the Internal Revenue Code, which establishes the need for these valuations.
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