Investor wants you to buy back their shares? Here’s what to do

Startup fundraising is, conceptually, quite simple: Investors give money to your company. You give them shares. Your goal is to make the value of those shares increase, so that one day when you sell your company, the investors get a significant return on their investment.

If an investor no longer want to be a shareholder in your company they’re welcome to sell their shares at any time. But they need to find a buyer for their shares. You’re welcome to help them find a buyer, but you’re not obligated to do so. And, importantly, the company is not obligated to buy out unhappy shareholders.

The rules of the game

Most investors understand the rules of the game, which is that once they’ve invested in a company, that money belongs to the company, and they can’t ask for their money back.

Of course there are other arrangements that would allow investors to get their money back – for example if they loaned money to the company, or they invested with a convertible note. But in those cases they would either get their money back or get shares. Typically not both.

But, back to our scenario here, which is something that many founders are likely to encounter… an investor who, some time after their investment, wants their money back.

Maybe they ran into financial problems and need the money. Or maybe your company isn’t performing as well as they were hoping. Or maybe you pivoted into a business they don’t want to be involved with. Or maybe your company is doing badly and they want their money back before your company runs out of money.

At some point in most companies there are going to be unhappy shareholders who want out, so knowing how to handle that is important.

Explain that the company can’t buy back their shares

So, the first thing is to talk the unhappy investor down from trying to sell their shares, by explaining the rules of equity investing:

1. An investor is free to sell their shares anytime, but they need to find a buyer, the company has no obligation to buy them out.
2. By law, a company can only buy out shareholders out of distributable profits, so if there aren’t any, then it’s simply not an option.
3. The company can’t use SEIS/EIS money for the purpose of buying out shareholders – if you do that, all shareholders will lose their SEIS/EIS (if they’ve held their shares for less than 3 years) and have to repay their tax deductions back to HMRC.
4. If the company offered to buy their shares, other shareholders might ask the same thing, and it’ll be a disaster.
5. If the investor got SEIS/EIS for their shares, and they’ve held the shares for less than 3 years, then selling their shares now means they lose their SEIS/EIS and have to repay the tax they deducted, back to HMRC. So if they invested SEIS/EIS, they are often better off keeping the shares rather than selling them, at least if selling them for much less than they paid.

Your goal then is to explain, why the company can’t buy back their shares, it’s just not possible, not gonna happen.

So if there anything you can do to help?

If you want, offer to help them find a buyer

Sure, you can offer to help them find a buyer. You’ll explain to them that there’s no obligation for you to do that, but you’d like to be helpful and you’ll ask around. As a practical matter that usually means writing to some or all existing shareholders asking if they want to increase their shareholding in the company because a shareholder needs to sell.

Before you do that, you might try to establish what price the departing investor is willing to sell at – depending on how business is going that could be the price they paid for their shares, or an increase on that price, or potentially a big discount to that price.

Once you have some ballpark figure in mind – noting that the actual price is something they’re going to be negotiating directly with the buyer, you’re just doing some expectation management so you don’t waste your time messaging your shareholders that someone is looking for a buyer at a price that nobody is going to pay.

Watch out for SEIS/EIS

One thing to note – and to let any interested buyers know – is that they won’t get any SEIS/EIS on those shares – only newly issued shares can get SEIS/EIS, shares bought from someone else can never qualify for SEIS/EIS.

There’s another gotcha that most people don’t know about, which is that once an investor has bought non-SEIS/EIS shares in a company, they can never invest SEIS or EIS in that company in the future. HMRC’s reasoning is that if an investor was prepared to invest previously without taxpayer-funded inducements, there’s no reason to give them taxpayer-funded inducements now. This means that if you encourage an existing SEIS/EIS investor to buy shares from another shareholder, you may well lose them as an investor in the future, as they’ll be tempted by other companies that are able to give them SEIS/EIS benefits.

What if nobody wants to buy their shares?

If nobody wants to buy those shares – or you don’t want to look for someone to buy their shares or ask other shareholders if they want to buy – there’s another option… you could buy them.

If you have spare cash, there’s no inherent reason why you, a founder, can’t offer to personally buy out that shareholder – your equity in your company increases, which is nice.

It should be said that if you had spare cash and wanted to increase your % equity in the company you’re probably better off investing in the company directly (so that the company gets the cash) rather than buying out a shareholder (when they, rather than the company, get the cash).

Since it’s your money there’s nothing to say you can’t use it any way you want… which you may need to let other shareholders know if they say, hey, we want to sell our shares too, you bought Bob’s, you need to buy mine. Well, no, you just did a favour for Bob, there’s no obligation to do the same for anyone else.

I mentioned that as a founder you could buy out an existing shareholder if you wanted to… but don’t feel pressured to do so. As founders we put years of our lives into building a company, at a lot less pay than we would get being a contractor at some big company. If an investor asks you to put more of your money into the business (and you don’t want to), explain to them that all your eggs are in this one basket, it makes no sense for you to increase your mortgage to put more money into the same company that is paying your salary – after taxes – to pay off your mortgage. Investors invest money, you invest time and dedication, that’s the pact.

Remember preemption

Unless you’re still on the Model Articles that you automatically got when you incorporated, your company’s Articles will usually have Preemption on Transfer rights, when means a selling shareholder needs to offer their shares to all existing shareholders before they can offer them to a buyer. This is designed to allow existing shareholders to take advantage of someone wanting to sell their shares before an outsider can get them – for example, if a shareholder wanted to sell their shares to a competitor of your company, your shareholders could rally together to buy them first.

This means that, regardless of who offers to buy the selling investor’s shares – including you as a founder being happy to personally buy those shares – the selling shareholders will still formally need to offer them to all existing shareholders first… which means there’s no option of a ‘secret’ sale, everyone’s going to be aware of it when they get the preemption letter that you have to send out.

The £1 Put Option

There is a twist to this, known as the £1 Put Option, which is the right that some investors ask for (and which is then contractually agreed in the Articles) which gives them the right to sell all their shares for £1, and the company is obligated to buy them out… for £1. Put Options cannot be used if the investor(s) plan to get S/EIS on their investment. Read more on HMRC guidance.

What madness is this, I hear you say… why would an investor want to lose their entire investment by getting back just £1 for all their shares?

The reason is that some funds have mandates that only allow them to invest in companies that meet certain conditions. For example, your company may need to be headquartered in a particular country. Or not be involved in the adult entertainment business. Or align with their ESG mandate.

If your company ceases to align with the investing fund’s mandate – or your business simply becomes an embarrassment for them – they can exercise their £1 put option to get rid of all their shares at any time, which the company will then buy from them for £1.

From the perspective of the other shareholders this is of course just fine – everyone else’s equity % goes up. If you do round funding round on SeedLegals, if an investor asks for a £1 put option, that’s a 1-click option for you to add in your funding round legals, you’ll find it in Advanced Terms in the funding round workflow.

Loss relief

One, perhaps surprising, reason why an investor may want to sell their shares is so that they can claim loss relief on their investment. So long as an investor keeps their shares they can’t claim any loss on them, even if they realise the shares are worth nothing.

However, if they sell those shares, even for nothing, then at that point they’ve incurred a loss, and they can claim loss relief on their investment.

It’s also possible for investors to be able to claim loss relief if the company goes into administration or they manage to obtain a nil value valuation on their shares, but the fastest and easiest way may be just for them to sell their shares back to the company for nothing.

More on loss relief here: SEIS and EIS loss relief: What is it and how can your investors claim it?

How about you wanting the right to buy out your investors?

In this article we covered the scenario where an investor demands that your company buys them out. But what if you wanted the right to buy them out? See this article for more on that.

Summary

In summary, if you have an investor who wants the company to buy back their shares, your goal is to explain to them that the company has no obligation do so, and will not do that. However, you’d be delighted to make some calls and, as a favour, see if you can find a buyer for them.

Generally that’s as far as you’d go.

But, if an investor is so painful that you’d use your own money just to be rid of them (and you have the money), sure, you could buy them out personally. If you wanted to.