This is the second guest post from Dave Broadwin, head of the Emerging Enterpise Center at Foley Hoag LLP, in the area of founding agreements. Part one is on vesting and the other related posts are on improving the performance of founding teams, founder agreements and strategies for dealing with poorly performing co-founders.

Back by request, a post on repurchase rights and related concepts.  These concepts pertain more to companies that are not venture financed than to companies that are venture financed.  Why?  Because when VCs invest, they cover off all these concepts in their basic investment docs.

The issue sets up like this:  You and three friends (Mark, Luke and John) decide to form a company to found a new social network.  You have checked out what Sim Simeonov has to say about vesting, so you figure you have it knocked – until you go talk to your lawyer.

The first words out of his mouth are, “Well Matthew, what if Mark, Luke or John leaves the company and goes to the dark side?  What if one of them becomes disabled or dies or gets a divorce or goes bankrupt?  You might find yourself with a partner you don’t want.”

There are a number of ways of dealing with these issues.  They begin with transfer restrictions, move on to repurchase rights and obligations, go through a process for determining the purchase price and end up with an agreement around payment terms.  So let’s take the tour.

The tour is all about how to anticipate and prepare for the situation in which one of your co-founders leaves the business.  The far more common situation is that the founders come to a parting of the ways or they need to reallocate equity for reasons of nonperformance or noninvolvement and there is no agreement in place.  So, first a few words about that.

Equity Reallocation Without an Agreement

In my last guest post, I suggested that perhaps you would need a prescription for Nexium in these circumstances.  I repeat my suggestion.

In the absence of an agreement, you are going to have either a negotiation or you are going to have to dilute the departing or non-performing founder (or consultant or whatever).  It is hard to imagine a circumstance in which a negotiated result is not going to serve you best over time.  So, unless something about the situation or your lawyer’s advice dictates otherwise, your best course of action may be to have a come-to-Jesus meeting with the other person and explain what you want (i.e. a give up of equity either in the form of a simple contribution back to the company or a sale at some low price) and why it makes sense for the company as a whole and, therefore, for the other person as a shareholder.  If that works, go for a release while you are at it.  Your lawyer can help you with that too.

If the negotiated route does not work, you are going to be looking for ways to dilute the former founder.  Anything you might do here is fraught with potential corporate law and tax law consequences.  You should not start issuing shares or options without legal advice.  Just to make the point, if you issue yourself a bunch of shares, that could be taxable income.  Also, issuing shares at less than fair market value could be a breach of the fiduciary duty of directors and could expose them to a lawsuit from the disgruntled party.

All this, of course, argues that you should be prepared lest you end up in founder Purgatory or worse founder Hell.  So, now at long last, the tour:

Transfer Restrictions

Most stockholder agreements begin with the same basic commandment, thou shalt not “sell, assign, gift, loan, pledge, mortgage, hypothecate (that one sounds ominous), distribute, encumber, or otherwise transfer or dispose of “ thy shares, unless … There are really two points here.  First, you really can’t sell (etc.) your shares to anybody under any circumstances.  Second, is the stuff that follows the word “unless.”

“Unless” is usually followed by a variety of exceptions to the principle of no sale.  These exceptions include some, or all, of the following:  (1) pursuant to a bona fide purchase offer from an arms-length third party after first providing the company and/or the other stockholders a right of first refusal, (2) pursuant to bona fide estate planning (with the proviso that the recipients remain subject to the basic transfer restriction), (3) upon death or disability, (4) pursuant to a divorce decree or (5) upon bankruptcy.

Think about it this way:

Mark can sell his shares to Satan, but only after giving the company and the other Apostles a chance to buy them (usually on the same terms and conditions as offered by Satan).  Sometimes you see flat out prohibitions on sales to competitors.

Luke can put his shares in a trust for anyone he begets, but if he does that, the begotten can’t make further transfers unless they comply with the basic transfer restrictions.  Same result if Luke dies or becomes disabled and the shares go to some trust or other.

If John gets a divorce, then the shares can be transferred by court order in the divorce.  There is not much you can do about that, except get the spouse so sign something beforehand or provide for repurchase by the company and the other stockholders pursuant to some fair valuation.  Similar issue if John goes bankrupt (only the bankruptcy court has even more control than a divorce court).

Repurchase Rights and Repurchase Obligations

A departing stockholder may be required to sell and/or the surviving stockholders may be required to buy the stock of the departing stockholder.  This type of arrangement has the following results:

• It may provide liquidity to the departed, depending on the price per share
• It permits the surviving to retain 100% of the ownership
• It prevents undesirables from becoming stockholders

You can also mix and match.  Under some circumstances you may want repurchases to be mandatory and not under others.  For example, stockholders often want repurchases to be mandatory upon death or disability because they foresee the need for liquidity.  Sometimes they want the right to be optional in the case of a sale to a third party because they don’t want the company (or themselves) to be obliged to make a payment they can’t afford but they need the security that they can prevent a sale to a competitor.  You want to consider the needs of the company and the stockholders to decide what works for you.

What is the Purchase Price?

There are probably as many ways of setting a price as there are people wanting to set one.  However, there are some that can be described as typical or usual.  In any event, they are more common than others.  These are (1) in the case of rights of first refusal, the price set by a bona fide third party offeror, (2) formula pricing, (3) appraisal, and (4) the mutual option method.  Sim has pointed out to me that he sometimes sees 409(A) valuations used to determine fair market value in shareholder agreements that apply to many shareholders.  While I can’t say that I have seen this done, I can see that it could have great appeal.  You will have an objective third party valuation.  However, these valuations sometimes seem low.  So, representing a senior exec, I might go for something else.

In the case of rights of first refusal, the right is always (almost always) the right to preempt the proposed purchase by a third party.  It seems inherently unfair to set the price at a number different from that which a bona fide willing third party has offered.  Enough said on this one.

Formula pricing offers the illusion of objectivity in the guise of ease of calculation.  Typical formulas are things like multiples of revenue or EBITDA or even, sometimes, book value.  Formulas can, and do, work well in situations where the company is well-established in an industry where companies typically sell on some established basis such as a multiple of EBITDA.  Having said that, this approach may not (almost certainly won’t) work for early stage companies or technology companies where there is real value in the technology.  If a company has no revenue, it will not have positive EBITDA or, frankly, any other balance sheet number that can be used in a formulaic way to set value.  But, this is not to say that the company has no value.  For example, the exclusive right to sell indulgences may not have achieved revenue, but it sure could have value.

Once you give up on formulas, the typical fall back is appraisal.  In my experience, clients like to go with a neutral knowledgeable outsider such as an investment banker to do the appraisal.  There are various methods of choosing the banker such as the parties agreeing or if they can’t agree after some amount of time, each picks one banker and the two so chosen pick a third banker who does the valuation.  This method can, of course, be expensive since the banker has to be paid.  Another possibility is that the independent directors (if there are any) pick.  I have even seen baseball arbitration used in this context.

A final method that I mention because it is used more often than I ever expect (which is not to say that it is used all that often) is the mutual option.  The way this works is that, at a stated time, either party may set a valuation and the other party may then elect to either sell at that valuation or buy at that valuation.  For example, in a simple case where there are only two founders, Luke and John, one founder, Luke, sets the valuation and the other founder, John, elects whether to be a buyer or a seller at that valuation.  If Luke sets the valuation too low, John will buy out Luke but if Luke sets the valuation too high, John will sell out to Luke.   This method pushes people to pick reasonable valuations because the risk giving away the store if they don’t.  It has other drawbacks, however, for one, it is difficult to make work if there are more than two parties.  For another, it favors the financially stronger party.  If one party can’t come up with the money to be a buyer, then they are likely to end up selling at a low valuation either because they themselves are constrained to pick low valuations or because the counter party figures it out and is artful about how they set the valuation.

In the End: Payment

In the case of rights of first refusal, usually payment must be made in the same manner as that which the third party buyer has proposed.  On occasion, however, thoughtful entrepreneurs take into account the possibility that a large sum could have to be paid in a short time frame and provide some sort of payout mechanism in the stockholder agreement.

Unlike the situation with a right of first refusal, in the case of appraisal and other valuation methods, the payment method should be set forth in the stockholders’ agreement.  Usually the stockholders agree on some portion to be paid at a closing and the rest to be paid over time.  Often the timed payment is in the form of a note that bears interest and may, or may not, be secured.

Dealing with Disputes

Needless to say, when these situations come into play, there are many opportunities for disputes.  It is hard to say anything good about disputes and how to resolve them.  Disputes among founders are almost always fraught with emotion.  This makes them very intractable.  Many people have tried to find cheap and easy ways to resolve disputes.  These ideas sometimes make it into shareholder agreements.  The typical approach is some form of non-binding mediation for some period of time followed by binding arbitration.  A lot of clients are of the view that this process will be less costly and less time consuming than a court proceeding.  They may be right, but it is really hard to know.  Also, there is the belief, which may not be correct, that arbitrators tend to compromise, compared to courts that just decide who is right and who is wrong, thereby reducing risk to all parties.  Again, this may or may not be true.  I am not aware of any objective evidence one way or the other.  Just to give you a rough sense, our firm handled litigation between founders, one of whom was a client of mine, that went all the way through a bench trial (it was tried before a judge and not a jury).  The cost for our client, who won the case in its entirety, was just under $250,000.  We handled a different case, also for one of my clients, where we hired a solo practitioner in California to handle the arbitration.  He agreed to take the case on a contingent fee basis.  Again, we won a sweeping victory.  The contingent fee lawyer got one third of $2million and this was on top of our hourly fees, which were trivial by comparison.  Keep in mind these are the costs of the winners.  There were approximately equal costs on the other side, and they both lost and paid material fees.

As you can see, my experience is that neither method, arbitration or lawsuit, is cheap or easy.  While I also believe that judges and arbitrators actually believe (and behave as if) they are in the business of delivering a just and fair result, irrational things creep into both processes and can affect the results.  For these reasons, I often advise clients that it is in their best interests to find a compromise before getting into a formal dispute resolution process.  Not to be too flip, I actually often tell clients that if everyone is equally unhappy with the result, then it was probably the right result.

One more piece of advice, and this is certainly self-serving, if you really are going to go all the way to trial (or its arbitration equivalent), don’t be penny wise and pound foolish, hire a good lawyer with experience in the type of dispute you are dealing with.  You will be dealing with enough risk; don’t add an inexperienced attorney to the mix.

As far as I know, Matthew, Mark, Luke and John are still together enjoying the fruits of their labor in heaven.  I don’t know what your chances of getting to heaven are but your chances of avoiding Hell are better if you think about and deal with founder issues at the beginning than if you don’t.

Let us know what you think in the comments or on Twitter @simeons and @broadwin.