Dec 6 2006 by Jason

How Do You Deal with Founders Stock When Some of the Founders Leave the Company Early?

Question:  I have seen two pre-funding startups that have had 1 of 2 and 2 of 3 of the original founders quit. Neither of these companies had founder buy-sell agreements.  In the latter case, the 3 founders had split the company equally which means 66.7% of the ownership is now outside and passive.

Fortunately, they realize that this is a non-starter when the current company reaches a point (soon) of funding and are willing to give back significant ownership.  What is the best mechanism for the company (C Corp) to absorb enough of the outside founders’ shares without serious tax ramifications?

Our Take: There are three ways that we’ve seen this work. In any of these scenarios, there are important legal considerations / risks to consider. Please consult your lawyer.

1. Recapitalization of Stock. Chances are if the founder left, the company wasn’t white hot. In fact, our bet is the company isn’t doing well at all. Someone could put in a bit of money and recap the whole company washing people out to what they should have, then grant new options (that can be partially vested on day one) to those who are left.

2. Company tender. The board of the company determines the FMV of the company and then company buys back for FMV. Again, assuming the company isn’t super hot, the spread should be little or even negative.

3. Company buyback and release. The company could buy back the stock for $X in exchange for the founder shares coming back into the company and a release. Make it a release of potential claims. The company pays cash for the stock. Whatever the spread on the stock is, can be expensed by the company as a payment to protect business reputation.