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You’ve tried your best to repair a bad relationship with an investor and the last thing you want is a broken cap table, so it’s time to consider seriously getting that investor off your cap table altogether. The good news is that it’s not impossible. The bad news is that it’s very hard.
The first step is to identify how you would repurchase these shares before even approaching the recalcitrant investor. You’ll want to get a fully fleshed out proposal fully backed when you approach them. After all, your relationship isn’t going that well; coming to them with a half-formed idea may not be well received.
Option 1: Company
The company repurchases them. You’re a startup, burning through cash to grow fast. Using that cash to buy back shares isn’t likely high on your list of things to do unless you’re rolling in money and the buyback amount is very small. You’ll have to convince your board and investors that this is a good use of company money.
If you’ve raised money via the NVCA/CVCA model documents, the good news is the company has first priority in the right of first refusal (ROFR). Having a ROFR makes things easier from a paperwork perspective when the company is purchasing the shares. More on ROFR and co-sales later.
Pro:
- Easiest.
Con:
- Less likely to have cash available.
- Unlikely to get board and shareholder approval.
- Price.
Option 2: You personally
The next easiest option will be to buy/repurchase them yourself. Same problem as the company, you may not have the funds to do this. If you have raised an equity round and have a shareholder rights agreement, you likely have a clause for right of first refusal and co-sale. In a nutshell, this means anytime someone is selling and buying that all the other investors have the right to piggyback on either side, pro-rata!
Worst case, if your bad investor owns 10 percent of the company and everyone else piggybacked on the sale rights, you may end up buying only 10 percent of their shares. So you’ll likely have to get all the other investors to waive their ROFR and co-sale rights.
Pro:
- Other investors will like to see the founder’s share going up.
Con:
- You may not have any cash.
- Triggers ROFRs.
- Price.
Option 3: Current Investor(s)
Same theme as Option 1 and 2, except now you’re talking about someone who may have funds. This is looking promising!
Whenever you have someone leave the cap table on unhappy terms, you are generating a long-term pain.
The astute reader will have noticed up until now the con of price. Now for the bad news about setting a price outside of a financing round. When negotiating a price you’ll want to make the case for support neither too high or low. If too low, it’s going to make for awkward conversations when fundraising for your next round. Too high, and your company, you, or current investor may be overpaying for these shares.
In particular, the risk of setting a price between insiders when one investor is leaving the cap table, and no outside independent party is coming in, comes in the form of a long-term liability in the event you are widely successful.
There is a risk, in a windfall situation, that the bad investor comes back and claims you didn’t sufficiently inform them on how well you would do, and if you had properly disclosed how well you were going to be they wouldn’t have sold their shares.
It’s a long-term liability because every time you do a round, new investors will ask lots of questions around this buyout, likely calling the old investors to see how litigious they may be or become. Proceed with internal rounds with caution.
Pro:
- Likely have the money.
Con:
- May want to put money in the company, not the pocket of another investor, especially if they are a bad actor.
- Same ROFR triggers.
- Price.
Option 4: New Investor
Fresh blood! The big benefit of a new investor coming in is that you have an independent setting or accepting the price, presumably with full access to due diligence in which to confirm the valuation.
You still have the same ROFR issues to deal with, but at least you’ve blunted the argument of what a fair valuation is.
The hardest part of this option is finding an investor who wants to purchase shares in the company by buying out an investor instead of putting fresh capital into the company. Most self-respecting investors would want to put fresh capital into the business.
Pro:
- They have funds!
Con:
- May want to put money it in the company, not in the pocket of another investor, especially if they are a bad actor.
- Same ROFR triggers.
Option 5: New investor, as part of a round.
I save the best option for last, but of course, it’s the most complicated. As you raise a new round, make it sufficiently oversubscribed that a portion is allocated to buying out your unhappy investor. This method has the benefit that the price is set by a third independent party, reducing the likelihood of litigation down the road. You may be able to make the buyout a condition of the financing, increasing the likelihood of getting the investor off your cap table. If the financing of fresh capital is the large majority of the round, it’s less likely anyone will be put off by a secondary to your unhappy investor. Lastly, this option is less likely to end up in litigation down the road.
Pro:
- Have funds.
- Condition of financing.
- Can deal with ROFR as part of financing.
Con:
- None really!
Once you have a plan in place that you can execute on it’s time to approach your unhappy investor with your proposal. Whenever you are thinking of firing someone make sure you document everything! If you have prepared diligence packages, it’s important you make these available to your leaving shareholder as well.
It goes without saying, but I’ll say it anyway, that you should consult your corporate lawyer whenever considering firing a shareholder.
Lastly, whenever you have someone leave the cap table on unhappy terms, you are generating a long-term pain. But it may very well be worth it in return for ending the short term pain of dealing with this investor. But don’t assume because they are gone that they are really gone.
Sarah’s take
I don’t agree with Christian when he says that “most self-respecting investors would want to put fresh capital into the business” rather than buy out existing investors.
Secondaries are an increasingly common strategy for VCs who are looking to increase their ownership in companies where the founders are dilution-sensitive. This is what Christian is getting at in his fifth strategy – but I think it’s important to clarify that secondary purchases are not stigmatized in the investor community. Some VCs take a passive strategy and are happy to only purchase via a secondary transaction, taking the strategy that it’s better to own a small piece of a big business, than a big piece of a small business. Other VCs will consider secondaries when they can’t meet ownership targets through a strictly primary investment, either as part of the primary round itself or as a strategy for subsequent rounds. There are entire funds that exist solely devoted to secondary investing!
There are lots of hurdles to getting this kind of deal done – especially around fair pricing – but finding a self-respecting investor willing to do a secondary isn’t one of them.
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Photo via Unsplash.
