How to structure equity buyout?

Question

Years ago, I helped out a friend on his startup as a software engineer. Spent ~500-600 hours on it, was compensated a little under half my hourly rate + 4.5% equity in the company, because the company wasn't really making any money so equity was a pretty easy thing for them to hand out at the time.

I've been uninvolved for a few years and the company wants to get serious investment now, with a company valuation in the low millions. They want to buy my equity out so they have a clean cap table when talking to investors.

The company still doesn't really have any money and offered me about 1k/% and floated the possibility of an earn-out in the event that the company exits. (I understand this is a pretty crap deal given the company valuation, but I'm not willing to hold their toes too close to the fire since it's one of my best friends.)

The earn-out specifics are up in the air yet, but I'd like to move it towards some % return if the company is bought out. I'm a complete novice when it comes to business agreements; how can I structure this so that I'd see some return in this eventuality?

Answer 1

The bottom line is that whatever you two agree on is fair. Having said that, if the company is worth 1 million your equity is 45K, 3 million 135K.

Offering you $4,500 is ridiculous and you may want to second guess your friendship. If investment was still a ways off, offering you 50% of what is owned is reasonable. However that is not the situation. You really are in a position to ask for more than what your equity is worth, friendship aside.

Saying some thing as simple as "no", or "that is not going to work" is a power move as they are the ones motivated to make you go away. If pressed you can answer with something like:

"I thought we were at least decent friends, but your offer makes me rethink that. Offering me less than ten cents on my dollar of equity is a bit offensive. Did you really expect me to agree to that? Perhaps I need to see a lawyer."

A reasonable offer would be to convert your equity into debt and you can even do it interest fee provided payments are made on time. If your reasonable equity was 100K (2.2 million valuation), then 20 payments of 5k would be a gift from you to your friend. This would work well if the company has healthy revenues.

You could always accept the deal, as is, giving your friend a significant gift. Even doing that I doubt this friendship will survive much longer. It seems the money is more important to this person that their relationship with you. Sorry about that.

Answer 2

It isn't possible to give advice on your specific situation without actually knowing the value of your current equity. Get a lawyer to represent you and give specific advice, including possibly hiring an accounting firm to look at the numbers and give a sense of valuation.

If paying a couple grand to a lawyer and a couple grand to an accountant isn't worth it for how small you think this is worth, then it doesn't much matter how it is structured. But hiring expert opinion should not be viewed as 'unfriendly'. When mixing friends and business, it is even more important to act based on expert opinion; that is the only thing fair to both you and him.

Perhaps the company is 'worth' $1M, but is that only the case if it gets someone to invest new money, and otherwise value will stagnate? In that case, your 4.5% might not really be worth 45k, if the only way to attain that value is to attract a buyer that refuses to allow minority shareholders. At the same time, turning something potentially worth 45k into a 5k payout seems like a huge cut. An earnout clause that gives you the potential to top-up the value based on future earnings may be one method to achieve fair compensation without scaring off a future buyer for the threat of a minority shareholder [which are generally disliked in buyouts for a lot of reasons].

Whether any of this is true, or how true it is, will depend on the specifics of your scenario. Almost impossible to say without actually having an independant expert review of the company financials, the legal framework of your current equity ownership, and the potential incoming buyout. Once again I'll say - getting an expert opinion is maybe the best way to remove emotion out of dealing with friends, and could be the best thing for both your return on investment and the friendship itself.

Answer 3

There's a very simple solution to this. You own 4.5% of a company whose valuation is difficult to determine. Were it simple to determine, it would be obvious that you would be entitled to 4.5% of that valuation.

Fortunately, the value is about to be determined. They're negotiating a funding round. That will require arms length negotiations between the founders (who want as high a valuation as possible) and the investors (who want as low a valuation as possible).

The obvious buyout price is 4.5% of the pre-money valuation their raise is based on. If they're offering you less than that, there needs to be some explanation of why.

The next step is if they agree that this is the fair value of your equity but that they simply can't practically hand you that much cash. In that case, an earn-out arrangement could be discussed. But the value of the arrangement would have to be reasonable equal to the value of the equity you are giving up.

Another option is for the sale of your 4.5% to be part of their raise. Along with whatever they're selling, they can also sell your 4.5% and pay the cash to you. If they can't do that, they should explain why.

If necessary, remind them that you took precisely the same risk that their new investors will be taking, except you took it on a smaller, riskier company. You are fully entitled to the same benefits their newer investors are entitled to.

Bluntly, it sounds like they are dealing with you as an inconvenience to swat away and not as a friend. I hope I'm just reading too much into your words.

Answer 4

The other answers don't understand the concept of raising capital.

First the principle investors will ask you to clear your books minus the current leadership team. You are part of clearing the books because investors want as high of a return as possible and your 4.5% is in the way.

In reality your 4.5% is NOTHING - N O T H I N G. Some companies are leveraged beyond 80% when raising capital.

Why would they ask to buy you out? Obviously they think they will fail and want you to get what you deserve (sarcasm). They are screwing you bud. They think they will be worth a lot more real soon and want to give you less. That is in essence the only reason someone makes this deal with you. And given they know more about their business than you... you got the short stick.

You took the chance of getting nothing for working - for that 4.5% - don't discount the risk you took. Whatever hourly sum you did not receive I would times it by 100 in your head for the risk level.

Here is an easy way to negotiate. Let's just say you agree on 100k... well only take that if they give you an option to buy back your 4.5% in 5 years at 150k... if they don't then your 4.5% is worth much more to them.

Also this company's value - being a startup - has almost nothing to do with its cash flow. They could have zero money and be worth 20 million. Or have 500k laying around and being worth... 500k. The fact that they don't have cash has nothing to do with their company value. No startup has cash laying around - if they do they aren't raising money.

To be clear - the OP has the best intuition on the future expectations of this company. I would advise that you keep the 4.5% unless you are totally blown away by an offer.

Answer 5

This seems to be a really simple calculation.

Your friend is about to get an investment. Presumably the investors are giving some sum ($X) for a percentage of the company (Y%). That values the company at X/Y. So if the investors offer $1M for 50% that values the company at $2M.

Your shares are worth 4.5% of that. That's all there is to it. If they are trying to negotiate you down, it's just because they are trying to make more money for themselves, and at your expense.

There are two issues that mean they probably do want to buy you out, and because of this I hesitate to call this a "rip off".

It's likely that the new investors do want to remove any possible shareholders other than them and the people actively working in the company. It's also true that they company is currently short of money, so they can't afford to buy you out at full value right now. However there are solutions to this:

1. They are about to get a boatload of money. Sign a contract with them agreeing that you will sell them your shares at their full value (state what the value is) after the investment deal is done. That removes the investor's worries that they have an unknown quantity with a stake in the company.
2. Agree to convert your shares to non-voting shares.
3. Agree to loan them the amount you should be paid for a while, at an appropriate interest rage.

Answer 6

Ever tried to buy something in a shady night market? The first offer is always ridiculous. The beginner asks for 25% discount - and has already lost, as he should have asked for 85%. That's happening to you right now.

Even if you asked them to double up on their offer, you'd be losing. Calculate what you think is the fair amount, and request 200% of it. Both parties can work from there on - not from whatwever they made up.

Don't let them fool you into the lines of "if they offer 1k, it's surely no more worth than 2". Their initial offer should have absolutely no bearing on your evaluation, rather consider it as an active distraction.