Early investor wants to cash out

Our company had an early partner that came in on the 'ground floor' and promised to one of the first hired employees. He invested money into the company for an partner's equity share (25%).

A few months down the road, he realized that he was not able to leave his day job and become a full-fledged partner as he had intended. He soon phased out of the company and because considered a 'silent investor'.

A while later, we were courting investment groups and offered to buy back 15% of this man's stock, with a nice return on this investment. He wasn't entirely thrilled about it, but realized that it was best for the company to do so.

Fast forward to today- the company has grown to 2 dozen employees and the growth hasn't shown any signs of stopping. This man has approached us and is wanting to cash out his remaining 10% of the company. He claims that since our company is now valued at a large sum, he would like 10% of that valuation.

We are having a hard time with this reasoning. Our company has grown, but we don't have anywhere near the liquidity to entertain that kind of buy out. We've offered him the ability to cash out his 10% with a generous amount of interest, but he refused. We explained to him that we'd be more than happy to cash him out at the valuated level if we were to be purchased, but at the moment, there are no buyers to be found and we're not actively looking at an exit strategy.

As a small business, how can you deal with early investors wanting to cash out at a high valuation but before a buy out?

bottom line as I see it: unless there is a specific clause in your op agreement or other similar document dealing with sale/transfer of ownership, the investor who wants to cash out has very little say in what happens next...

The investor has an asset that he wants to sell (stock in your private company) and his options for selling that asset are very limited in most cases.

From a legal standpoint, your operating agreement or other corporate type docs should detail how and when stock can be sold. Barring that...

An early investor in a risky business should understand the extremely limited liquidity with such an investment, and also respect the board/managers of the company when it comes to determining what to do in these situations. Since you, the other owners/investors would be the buyers of this stock, your valuation of the stock is all that really matters. I would be careful in setting a precedent, for fear that other owners may also then demand the same cash out opportunity. Could be a slippery slope.

One of the best clauses I've seen, and one we use in every LLC we create, is something along the lines of: At any time, any owner (owner A) can make an offer to purchase any other owner (owner B)'s interest at a price of owner A's choosing. Owner B has 48 hours to do one of two things - either accept the offer, or flip the offer around and purchase owner A's interest at the offered terms. Keeps things fairly even, ignoring any outside factors. I believe this is most useful in moving a business past an impasse where owners cannot agree on something. Also very useful in 50/50 partnerships, which I really don't like - someone has to have the final say in my opinion.

First of all, this post is a great cautionary tale for the importance of vesting which every founding group should put in. When people are putting in real cash, the company would have the right to buy back a declining percentage of the shares, at the price purchased, exercisable over a certain time period after the person left. If the company didn't buy back the shares, then the person would have them, and you would all understand and agree he had the 25%.

A lack of vesting led to the first transaction, where the first man kindly agreed to sell back 15% of his shares (from your point of view - he could call it extortion). In doing so, some goodwill was lost, likely on both sides. You both have still done quite well to arrive here. The question you had was how to handle it now.

You're in a potentially tricky situation now.

1. The best thing to do would be to find someone in one of the investment groups, who wants to buy this man out at, e.g., a 20-30% 'liquidity discount' to the current share price. This would be neat and clean (and in fact, you should tell him to find a purchaser himself on these terms if you can't do it - though it's better for you to find the person).
2. He has already done you a favor in selling back the 15% of the shares, so a fair thing to do would be to set up some sort of share buyback, whereby you agreed to buy back his shares at an agreed price (e.g., 80% of current market value) over a 24-36 month period. This would need an out clause where either of you could stop the transaction any month (if price seemed unfair to either of you). You could then renegotiate a new buyback.
3. The problem with solution 2 is that other people may want to sell out as well. You may have to set up the buyback agreement so that, e.g., 50% of the cash goes to him (as thanks for selling back the 15%) and the other 50% is split between everyone else who wants some liquidity. That's not great, but it's the best I can think of.

P.S. I'm not a huge fan of shotgun clauses (48 hour forced buy-sell clauses).

I wish you had used a dynamic equity split. This problem would have been easy. In a dynamic model the rules are clear about what happens when someone bails out early.