Entrepreneurs often make serious financial sacrifices when launching a company. After drawing a below-market salary and even tapping savings to build equity value, a founder may legitimately need some liquidity prior to the ultimate sale of the company. When a venture capitalist (VC) recognizes the value created and wants to invest, a founder sometimes proposes selling a portion of the founder’s shares as part of the transaction. Although VCs generally prefer that new money be used for company growth and that founders stay hungry by having significant skin in the game, a little early cash out may be necessary to win the deal. Several potential issues arise in such a situation, including:

Fairness
If the founder is a director or controlling stockholder, fiduciary duties to act in the best interests of all stockholders need to be considered. Approval by a majority of the disinterested directors, and perhaps even stockholders, may provide some protection. If the stockholder base is small enough, the written consent of all the stockholders could be sought (although any refusal could be problematic). Offering pro rata participation to all stockholders may require compliance with tender offer rules, including anti-fraud disclosure concerns, and other securities law issues.

Common vs. Preferred
Founders typically hold common stock while VCs typically want preferred stock. Thus, a VC may elect to purchase preferred stock from the company while permitting the company to use part of the proceeds to repurchase founder stock. This structure may also mitigate any concern that, after the shares appreciate in value, a disaffected founder may bring a claim against a VC that purchased shares directly from the founder.

Valuation
The rights associated with preferred stock make it more valuable than common stock. Should the purchase of the founder’s stock be at the same price as the preferred stock or something less? A lower price will require the founder to sell more shares to achieve the desired amount of cash, potentially reducing the founder’s motivation going forward. On the other hand, sales of common stock at the price of the preferred stock may effectively establish the fair market value of the common stock (especially if structured as a repurchase by the company) at a level that limits the ability of the board of directors to grant future options at attractive prices without adverse tax consequences under Section 409A of the tax code.

The ideal solution to these issues will depend on the circumstances. Although such transactions are rare, three real life examples follow.

One VC refused to link its purchase of preferred stock with the sale of founders stock but introduced the founder to a couple of angel investors who independently negotiated third party purchases of common stock directly from the founder at a price lower than the price of the preferred stock (and the holders of contractual rights of first refusal over sales to third parties waived those rights).

In order to avoid having any transactions in common stock, another company with only a half-dozen stockholders took the unusual step of reclassifying all of its outstanding common stock (but not options, which would have created adverse tax effects) into junior preferred stock and then allowing all stockholders to participate in a negotiated (which proved not to be pro rata) repurchase of junior preferred stock by the company.

Finally, a third company preserved the incentive value of competitive option pricing by engaging an independent valuation firm to value the common stock immediately after the preferred stock financing. The company then repurchased the number of shares the founders wanted to sell at that price (taxed at long-term capital gains rates), with the balance of the founders’ needs being addressed through a one-time cash bonus in recognition of past services (taxed at ordinary income rates).

Matthew G. Wells is a shareholder at Ray Quinney & Nebeker P.C. in The Venture Practice. Matt joined the firm after spending seven years with Wilson Sonsini Goodrich & Rosati in its Palo Alto and Salt Lake City offices. His practice focuses on the representation of public and private technology companies and the investors that finance them. He has substantial transactional experience in business formation, venture capital financings, mergers and acquisitions, equity public offerings and general public company representation. Additionally, he has negotiated various intellectual property licenses, software development agreements and distribution agreements and regularly advises boards of directors on corporate governance and equity compensation matters.