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Founder Stock Buy-Back Provision

founder leaving

What Happens when a Founder Leaves?

What happens when a founder leaves – because he or she wants to, or is asked to?  This is one that you’ll want to ask your attorney about.  But here are some thoughts.

When you’re building a founding team, it’s common to have the founders purchase (at a very low price) their stock to establish the cost basis of the stock — so a later sale is a capital gain, not income.  But what happens if things don’t work out, and the after 6 months, one of the founders leaves the company, along with his or her share of the stock?

That’s a problem.  If a founder leaves after a relatively short period, then they have not contributed that much to the success of the company, and you don’t want them to leave with a large share of ownership.  After all, the company will have to hire a replacement, and will need stock for that new person.  On the other hand, it’s reasonable for a founder that leaves early to leave with some portion of their stock.

One way to deal with that (and it’s something an investor is likely to insist on) is that all founder stock purchases will be subject to a buy-back provision (part of the stock purchase agreement between each founder and the company).  Basically this means that the founders do purchase and own their stock, and can vote the stock.  But if the founder leaves the company (by either their choice or the company’s choice) in some period of time (4 years is typical) then the company has the right to purchase back some percentage of the stock at the same price the founder paid for it.

For example, let’s say a founder owns 20% of the company, and the company’s buy-back provision states that 20% of each founders holdings are not subject to buy-back, but for the first year after the purchase, 80% of a founder’s shares are subject to buy-back, for the second year, 60% is subject to buy-back, the third year, 40% is subject to buy-back, and the fourth year, 20% is subject to buy-back.  After a full four years, there would be, in this example, no buy-back right remaining.  This is basically a 4 year “vesting”, but it’s actually a declining buy-back right, as opposed to a vesting.

So what does that mean?  Let’s say that founder left the company after 6 months.  He or she retains the 20% of the original 20% ownership (i.e., 4% of the company) because that “vested” up front.  The company has the right to buy-back the remaining 80% of that founders 20% ownership (i.e., the company buys-back a 16% share in the company).  So the founder ends up owning 4% of the company.

Now let’s say that founder leaves after 2 years, instead of 6 months.  After 2 years, the company has the right to buy-back only 40% of the founder’s stock.  In other words, the company buys-back 40% of the founder’s 20% ownership, meaning the company buys back a total of 8% of the company, leaving the founder with 12%.

The advantage of a buy-back provision is that it allows the founders to purchase all of their stock up front, establishing a cost basis, while at the same time protecting the company from one or more founders leaving the company after a short time, with a large percentage of the stock ownership.