In today’s funding environment, hot companies are gaining the upper hand in negotiating deal terms that would have been unheard of a few years ago. One such term we’ve seen recently in venture deals is partial liquidity to founders.

Many investors have come to recognize the benefit of reducing founders’ personal finance pressures before the “big exit” to free them up to focus on building bigger and better companies over the long-term.

Interim founder liquidity is achieved in two primary ways (usually in conjunction with a preferred stock financing):

Founder Share Redemption: Redemption of a portion of a founder’s shares by the company, using proceeds from the preferred stock investment to fund the redemption.

Direct Sale: Direct sale of a portion of the founder’s shares to investors as part of the preferred equity round.

Founder share redemption

In a founder share redemption, investors invest more money in the company than is needed to fund operations. The additional cash is used to buy back a portion of the founder’s shares, typically at a negotiated premium to the current price of the common stock. Here are some issues to consider with this approach.

Corporate governance: For a company to lawfully redeem shares, it must first comply with corporate laws concerning shareholder distributions. State laws have specific restrictions relating to corporate solvency, corporate waste and other fiduciary issues. Boards of directors often determine that companies’ interests are well-served by retaining founders though a liquidity incentive, but boards should always consider these issues carefully.

Anti-dilutive effects: When a company repurchases founder shares, the total number of outstanding shares decreases, leaving existing shareholders with a marginally larger ownership percentage in the company.

Tax reporting: Founders and the company must take a tax reporting position with respect to the share redemption. Depending on the redemption price, there may be a discrepancy between the fair market value (FMV) of the shares as determined for option granting purposes (discussed below) and the redemption price. In some share redemptions, any proceeds above the then-current FMV of the common stock are treated as compensation and taxed at ordinary income rates. Other times, the premium paid for the founder shares is treated as capital gains, recognizing that this approach may have more of an impact on the company’s common stock valuation after the redemption. Founders should consult with their own tax advisors prior to the redemption to ensure appropriate tax reporting.

Direct Sale

In a direct sale, investors agree to purchase a portion of a founder’s shares directly from the founder in addition to purchasing preferred stock from the company. Investors typically disfavor this method because they end up holding common stock, which lacks preferential rights. However, for companies with leverage to dictate structure, buying common stock may be the only way for the investor to acquire more equity. Here are the issues to consider with a direct sale.

Waivers and consents: If a company has previously taken in venture capital, its financing documents will typically require consent or waiver from shareholders with rights of first refusal and co-sale.

Fewer governance issues: Since a direct sale occurs directly between the investors and the founder, the company bypasses governance issues concerning insolvency, corporate waste and other fiduciary concerns.

Tax reporting: Generally, the same tax issues mentioned above apply.

Option pricing

Companies and investors often struggle with how to price shares in a founder liquidity transaction. While this exercise is more art than science, we’ve seen investors apply a 10 to 25 percent discount to the preferred stock price, which usually results in a much higher price than the current option strike price. Companies won’t want to peg their option FMV to the price at which founder stock was purchased, since the high price could “blow” option pricing and create challenges incentivizing employees.

One way to mitigate this impact is to characterize a portion of the amount paid to the founders as “compensation” income. However, founders may find this approach undesirable. To address this, we’ve seen companies obtain an appraisal of their common stock by an independent valuation firm immediately after the transactions that takes into account the founder liquidity event but does not rely solely on that price for valuation purposes.

Valuation firms often view the founder liquidation event as a “one-off” transaction where the company (or the investor) agreed to pay a premium for the founder shares. The valuation analysis may also distinguish the event if the founder sold a controlling stake. These arguments, while prevalent, are not immune to challenge by the IRS.

How much founder liquidity?

Typically between $500,000 to $2,500,000 depending on the size of the financing, how long the company has been in existence and its growth trajectory. The liquidity should be just enough to alleviate founders’ financial pressures but not enough to de-motivate them.

More founders, more problems

While it is customary to see interim liquidity reserved for a small number of core founders, companies may be tempted to expand the group to share the wealth. U.S. securities laws — specifically the tender offer rules — come into play when the founder group grows beyond a handful of people and may trigger a host of unanticipated timing and disclosure compliance requirements.

Companies and founders are well-advised to engage skilled legal counsel to help them navigate the pros, cons and other considerations of founder liquidity transactions.

Caine Moss is a partner at Goodwin Procter LLP where he specializes in representing technology companies and handles venture capital financing, M+A and public offering transactions. Alon Rotem, an associate at Goodwin Procter, assisted in drafting this article.

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