First Time Entrepreneurs: Fixing Your Capital Structure for VC Investment

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It’s a familiar problem faced by first time entrepreneurs:

Three founders get together and incorporate a company. They agree to split the shares equally, perhaps with some additional friends and family investment.  After six months, one of the founders concludes she can no longer support her family on peanuts and leaves, and the other two continue the business.

When the company subsequently seeks to obtain investment from venture capital firms or other financial investors, however, the continuing founders find that the business is unfinanceable due to the interest held by the former founder. In general, VC’s (especially early stage VC’s) are not going to accept that any significant interest is held by individuals who are no longer making a contribution to the business. Those individuals will need to be replaced in their roles, and their successors will require equity grants. What to do?

First, this is a first-time entrepreneur problem, because once founders make this mistake they’ll never make it again. 

It is important that founders enter into founder agreements that provide for “reverse vesting” of their shares. A normal market arrangement would be that the shares, although issued to the founders on day 1, “vest” over four years, with “cliff vesting” for the first year and pro rata vesting thereafter. What this means is that a founder who leaves in less than one year gives up all of his or her shares, and one who leaves after that time but before the end of the fourth year gives up some shares on a pro rata basis. 

Reverse vesting is a bit harder to accomplish in a UK company than in a Delaware corporation because of issues associated with a UK company’s acquisition of its own shares, but best practice in the UK is to include an articles of association provision providing for the unvested shares to be converted into “deferred shares” with no value. The British Venture Capital Association has developed a standard provision that addresses this.  

The articles may also give the company the ability to require a departing founder to sell at least some of his or her shares at current fair market value to a person designated by the company – this is reasonable since the founder will no longer be contributing to what could be very substantial further increases in value.

But what should you do if you face this problem and have not provided for reverse vesting?

Typically, you’ll need to have a sensitive conversation with the former founder, in order to persuade him or her to forfeit some of his or her equity. The former founder needs to understand that a small percentage of something of potential value is worth more than a larger percentage of nothing, and there is a high risk of the latter if the company can’t raise equity finance due to this problem. 

You may find it helpful to involve a “neutral” party in this discussion – someone who is knowledgeable about market practice, seen as credible by the former founder, and preferably, has no personal stake in the outcome. If that is unavailing, the potential financial investor, although an interested party, may also be prepared to have this conversation with the former founder.

In our experience, former founders generally understand that they are no longer making a contribution to the business and should not expect to retain the same interest as continuing founders – the usual issue, instead, is what level of forfeiture is fair under the circumstances.

By the way, you shouldn’t be surprised if the VC investor asks continuing founders to restart the clock on your existing “reverse” vesting, potentially even unvesting shares that have already vested. The investor wants to be sure that the management team in which it is investing is adequately incentivized to remain involved in the business. This is a negotiable item -- some recalibration of vesting schedules is likely to be appropriate, depending on the nature and stage of development of the business, but a full restart may not be reasonable under the circumstances.

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This discussion is not intended to provide legal advice, and no legal or business decision should be based on its contents. If you have any questions or comments, feel free to contact robert.mollen@friedfrank.com or via LinkedIn here.

You will find Bob’s other weekly blogs for emerging and growth companies on US issues, international expansion and early stage financing here: http://bit.ly/2lP5uMP

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