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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?

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    This doesn't quite seem like a question of personal finance. However, IMO you shouldn't undersell your share just to make their negotiations easier.
    – chepner
    Feb 11 at 14:38
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    @chepner This is a question on how to value a personally held asset [minority interest in a private company], so is generally on-topic for Money.SE. Feb 11 at 15:44
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    The value seems pretty clear: 4.5% of whatever the investor values the company at. The question seems to be a negotiation for how much less the OP will accept in exchange for relinquishing their equity.
    – chepner
    Feb 11 at 16:13
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    @chepner The value of the company = the value of OP's investment. A basic understanding of why the OP's partial ownership represents future value is critical to assessing how to approach the negotiation. For example - if the buying company is only willing to pay $1M for a company with no minority shareholders, is it 'truly' worth $1M... Feb 11 at 17:04
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    If they're trying to get you to accept £100k less than your equity is supposedly worth, then they're not your friend.
    – Kaz
    Feb 12 at 15:08
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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.

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    The concept of an earn-out clause is not necessarily rubbish, and is somewhat common in these types of deals. I presume the buyers don't want a minority shareholder, but yet at the same time if valuation is projected based on future earning potential only, then debt of say 45k+ might also be undesireable to the buyers [imagine if another 5 employees have similar arrangements; buying a $1M company with 200k debt isn't great], so a risk-reward mechanism like an earnout agreement might be the appropriate middle ground. Hard to know without knowing more about the financials. Feb 11 at 15:44
  • @Grade'Eh'Bacon: I'm not entirely certain if I follow you. Buying company with $1M in assets and $200K in debt for $1M is obviously a bad deal, but buying it for $600K is cheap. In general, $200K debt is not worrysome for companies that have a $1M valuation and annual cash flow
    – MSalters
    Feb 13 at 13:47
  • @MSalters It isn't clear from what the OP has presented, that the company does in fact have positive cash flow. The higher the debt of an acquisition, the higher the insolvency risk. In some cases, what you are suggesting makes a lot of sense - and might apply here. However in other cases, that extra bit of debt might make the risk of failure too high for the buyer to accept. The only reason I raise this, is for the OP to consider that this is not conclusively the owners acting maliciously. Feb 15 at 19:27
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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.

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    Not sure why my comment was deleted but I will rephrase it. There is no such thing as a lawyer that comes and evaluates a startup. The valuation of a startup would be best determined by private firm that specializes in capital in that sector. This valuation would cost the OP thousands of dollars and it is quite possible that their evaluation would be just as flawed as the OPs (given it isn't public they don't have to really disclose anything). So this advice is basically telling OP spend 10-50k and maybe get nothing out of it - when your 4.5% might not be worth the advisory cost...
    – blankip
    Feb 12 at 19:32
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    @blankip Perhaps I am biased as someone who has done this work early in my career, but I do think valuation services are worthwhile. The advice for a lawyer is intended for review of the current legal documents + potentially a review of future arrangements; the advice for an accountant is for purposes of providing insight into valuation of the business itself [and yes, it is quite likely that as a current shareholder, the OP has some type of right to access financial info, depending on the nature of the shareholder agreement and the corporate law jurisdiction involved]. Shouldn't cost 10k. Feb 12 at 19:46
  • What are you talking about? So someone is going to randomly find an expert in this field and is a lawyer and the company will hand over all bookkeeping and legal papers. This is fairy tale stuff that has no real world consistency. If this "lawyer" was good he would charge you at the very very least $500 an hour. You are saying he will get all of this done in less than 20 billable hours? He will review an entire company's worth in less than 20 hours?
    – blankip
    Feb 12 at 20:03
  • @blankip Yes to all. Feb 12 at 20:19
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    @blankip Well my personal bias is towards mid-scale accounting firms; depending on the market Big 4 might be good as well [kpmg.com, pwc.com, ey.com, deloitte.com]. I recommend a firm small enough that you can actually talk to a partner, but large enough that there are at least 10 accountants running around - try to hit the sweet spot of being able to reach the top level experts, but where they can delegate to lower-billing staff. To know which mid-market firms are right for OP I'd need to know their area. Maybe MNP or Grant Thornton in Canada. First call to find someone you like will be free. Feb 12 at 20:45
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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.

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    Great answer, very actionable. It's not clear to me from what the OP provided, whether the company is being overly shrewd, or if they are just new to this and trying very hard to appease the potential buyers. Feb 12 at 21:34
  • @Grade'Eh'Bacon I guess the nicest spin you can put on it is that they're very distracted and excited by the prospect of investment and aren't fully thinking through their friend's interests. Feb 12 at 22:04
  • This is by far the best answer. Others are good, mind, but it's beyond me how this sits at +4 when the others are at +13.
    – o0'.
    Feb 12 at 23:55
  • This is a good answer... because basically it is the same as mine but +1 for better wording!
    – blankip
    Feb 13 at 6:34
3

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.

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    A lot of conjecture in this post, and doesn't really get at the essential problem - valuing the OP's ownership stake will require review of the company financials by a professional, and a lawyer to review elements of current and future equity ownership agreements. Not every startup is the next Uber, and to claim that current cashflow doesn't impact valuation is misleading at best. The lower the current cashflow [note: cashflow <> cash on hand], the higher the risk of impending insolvency, and thus the lower the valuation. Buyout through debt may not be attractive to the buyer. Feb 12 at 13:52
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    @Grade'Eh'Bacon - your whole comment was conjecture. Just like your answer to have someone else look at the valuation that has no idea, just like the OP. Passing risk off at a price is a bigger risk than just going with your gut. There is no gained reduction of risk by having an outsider look at it unless they are truly an expert and the business gives them all the info they need. Meaning it is a flawed path because those are two things almost impossible for OP to get.
    – blankip
    Feb 12 at 19:36
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    No, my comment is not conjecture. Conjecture involves arguing a substantive point without the necessary information, whereas I am encouraging the OP to actually get that information. However, your answer includes definitive statements without having the requisite information to provide those statements. For example - you state that the OP should increase the value of their labour by 100x for the risk taken on. So, if he worked for a year at a labour rate of just $10 / hr, you are saying he should ask for $2M. I find that... unlikely to be reflective of fair value, even considering the risk. Feb 12 at 19:40
  • @Grade'Eh'Bacon - so the OP is the expert on this company and your advice is to send him off to someone like you - you said you did this sort of thing - for a better opinion. Because you not knowing the company from Adam and not knowing the sector and not knowing the technology imprints... someone like you would be able to go in and give a rock solid evaluation of worth.? I have one thing to say when people make claims like this - if there was an expert in this, they would make tons of money investing in startups that were undervalued... if you don't you aren't an expert!
    – blankip
    Feb 12 at 20:08
  • Now I'm confused. You state that the OP, who has worked ~500 hours, and billed half of them, should consider the remaining half of the unbilled hours to be worth 100x their normal rate, given the risk of taking equity. Assuming an unrealistically small fee of $20 /hr, that would mean a value for work performed of $500k. Yet you don't think the OP should try and achieve that value by seeking expert opinions [in fact, you seem to be implying that there is... no such thing as an expert opinion that could be gained]. [And btw, yes, accounting partners often invest in small businesses]. Feb 12 at 20:48
3

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.
2

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.

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    Can't say I've every tried to buy something at a shady night market, but love the sentiment. Obviously we can't know, but my gut says OP is being taken advantage of because he's a nice guy and wants to help his friend be successful despite any cost to him. +1, but think this should be combined with either grade'eh'bacon or blankip's answer, I say either as they're entirely different paths that I think both work for different people; balnkip's for those who aren't risk averse, and grade'eh''s for those who are - but that's conjecture on my part!
    – TCooper
    Feb 12 at 23:52

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