Being a startup founder is hard. Among other things, startup founders face long hours, resource constraints, intense pressure, and the need for constant adaptation and resilience in the face of uncertainty. Founders face all these tasks while also being severely underpaid, adding to the list of trials one of the more challenging: personal financial pressure.

As a result of such financial pressure, and the frightening uncertainty of success, it is not unusual for founders to consider a partial redemption or liquidity event in which they sell a portion of their shares to the company or directly to an investor, typically as part of a proposed financing round. Such a redemption provides cash to the founder in exchange for a reduced level of ownership and risk in the company. A partial redemption may be accomplished through a cash purchase directly from the company or by using a portion of the proceeds from a financing round. A partial redemption can be a strategic move with both advantages and potential drawbacks. Understanding the nuances of this transaction is crucial for founders and investors alike.

Why Consider Partial Redemption?

Several factors might drive a company to pursue a partial redemption of the founder’s shares:

• Liquidity: Founders may seek to cash out a portion of their equity for personal or financial reasons.
• Tax Planning: Partial redemption can offer tax advantages, especially when structured carefully.
• Corporate Governance: Reducing the concentration of ownership can improve corporate governance and decision-making.
• Employee Incentive Plans: Repurchased shares can be used to fund employee stock option plans or other incentive programs.

Key Considerations:

Before embarking on a partial redemption, several factors must be carefully evaluated:

• Valuation: Accurately valuing the company’s shares is essential for determining a fair redemption price. The company should review the current 409A valuation and consider the potential impact the partial redemption will have on future 409A valuations.
• Tax Implications: The tax consequences for both the company and the founder can vary significantly based on factors such as the founder’s holding period, the redemption structure and the company’s tax status. In general, a shareholder may exclude 100% of gain from the redemption of Qualified Small Business Stock (QSBS) for federal income tax purposes if certain issuance date and holding period requirements are met. However, a founder’s redemption may be disqualified from QSBS tax treatment.
• Corporate Structure: The company’s legal structure and governing documents may impose limitations or restrictions on share redemptions.
• Financial Impact: Repurchasing shares can reduce the company’s cash reserves and potentially affect its financial performance.
• Shareholder Agreement/Investment Documents: Existing shareholder agreements or investment documents may contain provisions related to share transfers, redemptions, rights of first refusal, right of co-sale or tag-along rights. The partial redemption may trigger rights for existing shareholders who may wish to participate in the sale.

Potential Drawbacks:

While partial redemption can offer benefits, it also carries potential risks:

• Dilution of Ownership: If the redemption is not carefully structured, it can lead to dilution of ownership for existing shareholders.
• Company’s QSBS: Impact on Qualified Small Business Stock (QSBS) for existing shares as well as future purchases.
• Market Perception: A significant share repurchase can sometimes be interpreted negatively by the market.
• Loss of Talent: Founders may feel less motivated or committed to the company after a partial redemption.

The decision to redeem a founder’s shares is complex. Early exits and partial redemptions can provide liquidity and diversification for founders while allowing them to maintain some ownership in the company. However, it is important to consider the potential risks, structuring options and tax implications before the company and founder engage in such a redemption.