Sunday, March 30, 2008

Investment Poutine: Buyback of Founder Shares

If you're in Quebec in winter (and it pretty much always IS winter in Quebec), nothing goes down better than a bowl of poutine. Poutine is a combination of french fries, cheese curds and gravy. It's a regional dish, and only Quebecois can make it well. This hasn't stopped many avant-garde restaurants and fast food chains from trying; it's on the menu in New York and Chicago, and the fast-food chain Harvey's tries to sell it,too. I don't blame them, but here's the thing: poutine just doesn't work out of context. In fact, removed from the charm of a candlelit apre-ski chalet, it's a tub of fairly nasty, congealed stuff.

The return of VC investors to angel and seed investing has led to a number of investing terms that, while they can make sense at the Series A stage, don't fit well in an earlier stage investment. For me, these are just so much financial poutine, and need closer consideration before you place your order.

Poutine #1: Buyback of founder shares. In a Series A deal, investors typically require founders to agree that a portion of their shares may be bought back if the founder leaves the company (or is fired) within the first few years following the investment. One underlying rationale of the Series A buyback is that the founders may not be the right team to scale the business, once the product and market have been de-risked by seed money. When negotiating this term, I always advise founders to insist that the number of shares subject to the buyback must be reduced in certain circumstances - most importantly, if the board fires the founder without cause. (You can read lots more on the topic by Nivi and the lads at Venture Hacks. There also are a number of other subtleties to this term, but let's leave that for another post).

In an angel/seed investment, the need for acceleration to protect a founder is even more compelling. In my experience, the period between seed and Series A is when most differences between investors and founders (and founders and founders) emerge. A broad right to buyback founders' shares at this stage can incent investors to replace founders who don't get along rather than trying to resolve issues. It can also incent investors to remove founders earlier, in an attempt to recapture equity that can be reallocated on a less-dilutive basis to post-Series A hires. (This raises the interesting legal question as to whether investors who exercise this right after firing a founder without cause are engaging in oppressive shareholder conduct. Lawyers for ex-CEOs ousted by VCs have advanced a number of interesting argumentss over the last few years along these lines. Since most of these cases have settled in Canada, there presently is little case law on the matter.)

To balance the incentives created by a buyback, I often advise clients to insist that NO shares will be bought back if the founder is terminated within the first year following the investment for reasons other than cause. If a founder steals from the Company, that's one thing. But unless the investment is a back-of-the-envelope kind of deal, any issues with founders should have been sussed out in due diligence.

As a founder, you might well agree that, if you leave the business and your angel investors high and dry, then they should be able to buy out most of your stake. But tread carefully when you extend that right. Ask yourself whether you are comfortable with forfeiting up to 75% of your stake in your company the day after you close an investment. Make sure your lawyer is fighting this point for you.

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