How to protect investors from founders leaving when out of money
We have founding partners who work for our start-up company full-time. We are now having a first external equity investor coming in. We have enough financing to last about one year at which time we target to break-even financially. Our new investor is concerned what happens if we run out of money and revenue is not high enough to at a minimum break-even after one year and due to that one or more founders leave the company and go for new challenges and they are left with the worthless company with no employees and no cash.
Are there any techniques legally to guarantee that investors are secured in that respect for some time period?
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This doesn't sound like a very sophisticated investor. – Zuly Gonzalez 12 years ago
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Is that something never heard of in startup investing? – User23570 12 years ago
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Quite the opposite. 1) Investors know that a majority of the startups they invest in will fail. An investment implies risk. You can't guarantee a return. 2) The terms may be structured in a way that reduces the risk for the investor, but a normal investor would know that. He would have his lawyer draft up the terms, not ask you to ask the Internet for advice. So, be careful. This is probably not a good match if you need more than just money from an investor. – Zuly Gonzalez 12 years ago
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So what would a normal investor then write to terms to reduce risk? – User23570 12 years ago
2 Answers
This is always a problem when investment is in people that can walk out the door (or get hit by a truck). Ultimately it is about faith/trust ... you can put in all the legal clauses and rack stock options to milestones but if the angel investor is the wrong fit for the startup, then it will only be a waste of dumb money. Some questions you should ask are
- has the investor actually run a business or been responsible for profit/loss line?
- do they know the difference between investment and a gamble? (what's their risk appetite)
- are they rich enough that if they had to walk away with nothing, they are not going self-suicide (of course it'll hurt but usually there's rules for sophisticated investors)
I seriously recommend you find the nearest angel group and try to find the best fit (market, investment philosophy, domain knowledge) ... it is almost like a marriage and nobody wants a hectoring mother-in-law.
Great question. There are several ways you can address this type of situation. In a stock-purchase agreement for the new investor, he may consider requiring the founders to stay on for a year. A different approach could be to structure the pre-mature departure of a founder as a trigger to compensate the investor.
Maybe the compesation of the founders could be changed to a merit-based system that will not drain the company if revenues fall.
It is fairly common for officers and especially founders to agree to a non-competition clause. This might also offer the new investor some security.
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We have non-competition clauses but in our case the founders can easily go to work for companies that are not considered as competitors. We have been discussing about those triggers you mentioned. Some compensation for the investors in case of premature departure. What could that be? – User23570 12 years ago
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...and considering that the founders are practically broke personally with no significant assets – User23570 12 years ago
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Additional equity alone is not likely to satisfy the investor, so perhaps the company buys some or all of the departing founder's stock at a reduced price and the investor has the option to buy. Maybe the investor is allowed to redeem options for cash. It could be voting rights. It could be other corporate assets. – Yorick 12 years ago
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The guarantee cannot come from the company since its likely there is no cash left in the company that could be used to buy investor shares. Company is already eligible to buy all departing founder's shares practically for free but that doesn't protect the investor if all the founders leave. I think the guarantee must come directly from each of the founders personally, maybe to buy back investors shares with a pre-agreed price in case of premature departure. But how can that be quaranteed since the price is pretty high and everybody knows founders are not the rich guys. – User23570 12 years ago
