Founders: sell your shares!
Why investors should encourage founder selldowns and when/how to sell your shares
Written by Daniel Szekely and David Mitchell: This is not legal advice and you should seek independent legal advice before engaging in a sale transaction.
EVP, like most VCs, often include restrictions on founder selldowns in our transaction documents, but we’ve never relied on them. Investors include restrictions like these for 2 fundamental reasons: (1) they don’t want to be left as a shareholder of a company that the founder has sold out of; and (2) they want the founder to be fully motivated. If they cash out millions of dollars at an early stage, there is a risk that they will lose some of the hunger derived from being ‘at risk’. The reasons investors include selldown restrictions are generally sound but the application of these mechanisms is often misguided.
In reality, we often encourage founders to sell down and have even forked over $millions to many different founders to allow them to cash out parcels of shares. One of my favourite people is Simon Lenoir, founder of Rezdy. Little makes me happier than observing him, his family, his new home and the journey he has gone on to become the awesome founder he is today. There are good reasons for selldowns and his 10 year journey as the Rezdy founder exemplifies this. We’ve supported selldowns in Biteable, Practifi, Rezdy, Deputy, Lumary, Fergus, Shippit and Practice Ignition, sometimes in circumstances in which investors were not supportive and we, respectfully, sought to navigate this dynamic.
Today I am writing a joint piece with my friend and colleague David Mitchell, Principal at Talbot Sayer. He’s one of the best in the business and one of the limited pool of awesome lawyers locally that ‘gets’ start-up. Critically, we outline below often overlooked circumstances in which founders are able to sell shares and pay no tax.
First, to the flawed logic of investors that too often inhibit founder selldowns…
The flaw in the rationale for selldown restrictions is the assumption that the alignment created by preventing selldowns improves business outcomes. The reality is that having founders that are ‘all-in’ in an extreme way can often impede performance and optimal decision making.
Founders need to live happy lives, pay mortgages, drive cars and go to the theatre. A founder under financial strain is not a person that is able to perform at their best. Cashing out $1 million to pay a mortgage will not make a founder less hungry. They haven’t risked it all to pay off their mortgage. Founders are almost always highly capable and they are able to pay a mortgage with their cushy corporate salary without a start-up. Assuming the selldown is not a sell-out, it will usually allow founders to live less stressful lives and allow them to perform their best.
Secondly, founders with too much at risk can struggle to make rational decisions in the face of the high risk, fast paced reality of early-stage start-ups. To run a start-up, you have to take calculated risks. A founder that’s scared of ending up on the streets if their company fails, will sometimes find it harder to make decisions in the best interests of the company. Ironically, sometimes the best business decision is one that presents more risk but a better risk weighted return. To make good decisions, the risk to the founder cannot be overwhelming.
Investors shouldn’t remove selldown restrictions altogether, but they should apply them in a way that allows and even encourages founders to partially de-risk as a business grows. In our case, we often have carveouts that allow for selldowns up to certain limits.
If you’re convinced by now that founders should sell down, the question is when. The answer is circumstance dependent but in summary: you should sell ‘as you go’ at key valuation inflection points, usually starting from Series B at the earliest. Deciding to sell down is a balancing act between de-risking today and delaying a sale to get more value tomorrow. My recommendation is to start making small selldowns at key valuation inflection points which often come at the point of a capital raise. For example, multiples in the US have historically been higher than in Australia. If your plan is to run an Australian raise now while you’re a local business, and a US raise in 2 years when you’re an international business, it would make sense to consider your first sell down at the time you revalue under US multiples. Founders should look to sell down over the journey as it both makes good financial sense to de-risk and it will empower them to be the best leaders they can be.
So, it’s 2024, you’ve hit your Series B, markets are roaring again (here’s hoping) and you’re considering a selldown. There are two CRITICAL things to think about when it comes to legals:
1. your ability to sell under your company’s constituent documents; and
2. the tax consequences of selling.
Regarding the first of these, it is common for constituent documents to contain a range of devices limiting your ability to sell shares.
Founder lock-up
The most relevant and often the most punitive of these devices is a ‘founder lock-up’, an absolute prohibition or restriction on sales by founders. Generally speaking, the starting point for these provisions is that a founder will be absolutely prohibited from selling shares during a period of time (say 2-3 years) after the latest capital raising round. As noted above, the rationale from an investor perspective is to ensure ongoing alignment and motivation given the founder is often absolutely critical to the investment case for financial sponsors investing in founder-led businesses. That said, founders should always seek to include a few handy carve outs.
Typical carve outs you should be looking to include are carve outs which allow you to (roughly from hardest to easiest to negotiate):
sell a certain pre-agreed number of shares or shares up to a certain agreed aggregate value (giving you a chance to realise meaningful upside while ensuring you remain fully engaged);
sell with the approval of the key financial investors without needing to get approval from all other ordinary shareholders;
sell your shares and terminate the lock-up in the event that your employment with the company ends due to circumstances outside of your control (think illness or incapacitation and even push for termination by the company without cause); and
sell into an exit event or in accordance with the compulsory transfer provisions (e.g. default or drag along) of your constituent documents.
Pre-emptive rights
Beyond the lock-up, you should also turn your mind to the pre-emptive rights provisions in your constituent documents which will likely require you to offer sale stock to other shareholders before selling (which is not likely to be a huge issue in the context of a capital raise) and co-sale or tag along rights which may require you to procure an identical offer for other shareholders’ shares before you can sell to a third party. Ideally you will be able to execute the sale referred to in the first dot point above without triggering the co-sale or tag along provisions at all.
Tax and the Small Business Concessions
Perhaps most importantly, you should seek advice on your ability to access the small business CGT concessions (SBC) which will allow you to reduce or defer the capital gains tax payable on a sale of your shares. In very simple terms, if you own more than 20% of a company and it has an annual aggregate turnover of less than $2M or total net assets of less than $6M (most start-ups have very few assets other than cash), you may be able to access these concessions which can significantly reduce or entirely write off the tax payable.
To give a simple example, if you were the founder of a business that was eligible for SBC and you waited until you were diluted down to 19% to sell $2M worth of shares, you would likely get a tax bill for $470,000 (based on a 50% discount to the highest marginal rate of 47% which most individuals are able to access and a total of 23.5% tax). If however you sold these shares while you held > 20%, the SBC would allow you to get further 50% discount on your tax bill, taking your tax down to $235,000. The SBC may then additionally allow you to roll this amount into your superannuation or into another investment for a complete tax write off. Needless to say, these savings can be hugely valuable.
So there you have it. Hopefully this article goes someway towards convincing all the founders and investors out there to change how they view and engage in exit transactions. If you’re a founder considering a sell down, remember to first consider both the legal limitations on your ability to sell and the tax consequences. Considering selling some shares while you hold more than 20% of the company if the SBC apply.
Thanks for reading. As always, I’d love to know what you think and always appreciate a share.
Happy investing,
Dan & Dave