Let’s review what equity is
When you established your company, you most likely issued some sort of stocks to your co-founders and other stakeholders. In its core, the equity you offered to your team is a promise of a future payment. The notion is that the stock will be worth much more in the future and it will have a cash value that can be redeemed. When a stakeholder wants to get out or you have realized that someone in your team is not delivering as promised, then it means you need to trade the terms of the initial agreement with new terms that work for both parties.
The payout process
Once the decision has been made by you or the stakeholder in your company, to go through the buyout process, you will need to make sure it is fair to both parties. You don’t want to hurt your fragile startup by cash depriving it, nor you want to make your (ex) stakeholders feel that they have not been compensated for the effort and time they have put helping you out with implementing your vision.
Converting stocks to cash at any given time is not an easy process and sometimes can become very expensive. The reason is that there are too many variables that play a factor to determine the current value of the startup stock. That is why the best time to do the buyout is probably just after a company valuation has been performed by a third party – for funding or other reasons. You need to rely on a number defined by a trusted institution, so you and your stakeholders are clear about the value you are discussing and share the fairness of the process.
There are few approaches that are worth reviewing and approaching in such cases.
Stock to cash over time
The fist that comes to mind and probably the easiest approach is to work out a schedule that satisfies both parties, of how the equity can be converted to cash over a set period of time. This simply means that you are managing the cash flow of your company while respecting the promise to pay your stakeholder the agreed-upon price. This may be a payment done over a 1-5 year period and it should account for the current stock price and the benefit that the cash is not taken out immediately in full by the stockholder.
Growth aligned payout
This might be seen as an (improved) version of the “stock to cash over time“ approach. In this case, both sides agree that the payment will depend on the annual company performance. It is fair to the company and maybe even advantageous to the exiting party since the startup is expected to grow year-to-year. It also has risks associated with it, related to the fact that a startup is a very high-risk investment and in many cases, the value may decline. Again, this approach seems to be fairer to both parties, because the payout is more dynamically related to the actual value of the asset.
The actual growth may be defined and negotiated – it can be based on profit, gross sales or other KPI that both parties find to be reasonable to define the buyout by.
This is the most difficult situation when the leaving party wants to have cash “now” for whatever reason. They may feel that the startup value will decline in the future or simply are pushed by other factors and need cash immediately.
In this case, you as a founder may have more leverage to negotiate the deal and you should be looking for a discounted price. In this situation, the value of cash is much more important than the value of the company. The need for an “immediate cash” deal emphasizes this.
Depending on how “immediate” the need for cash is, you may work on negotiating different discounts. Investment in a startup is a long-term investment and in cases when a long-term investment is converted to a short-term, it comes with an associated cost.
Good relationships are extremely important for a startup founder. It is your “soft skills” that will help you work with stakeholders who want to leave your enterprise and are looking to “cash-out” on their investments. This is not going to be an easy process and most of the times it will not be cheap, especially when your startup has real value. In the very early stages, before revenue and before funding it may be easier, since your startup probably has little to no value. Once you are funded and someone has put a number associated with your startup, things may become more difficult to resolve. Here is where the good relationship and soft skills come to play a role and your CEO skills may save or destroy your startup. Always keep stakeholders updated, happy and current on the valuations. Have defined KPIs so it is clear where you have been and what the trends are. Creating a business is much more than just creating a product or a service to introduce to the marketplace.