Want the right to buy out your investors? Here’s why that’s a bad idea

When you raise investment for your startup, the company will be issuing new shares to investors in return for their investment.

Investors have the ability to sell their shares at any time in the future… as long as they can find a buyer. That’s the natural order of things in the startup world: investors are generally free to sell their shares at any time, and the company has no obligation to buy those shares from the investors. The company cannot force the investors to sell their shares (other than on a sale of the company as a whole).

Now, occasionally at SeedLegals we get requests asking for either

1. founders asking for the right for the company to buy out its investors later, or
2. investors asking for the right to sell their shares

Both these requests sound reasonable at first glance but turn out to be seriously problematic – this article explains why.

In this article:

• Should you add the right for the company to buy out investors later?
• Should you give investors the right to sell their shares?
• What’s the £1 put option?

Should you add the right for the company to buy out investors later?

When you borrow money from the bank, the goal is to repay that loan to get the debt off your books.

When you raise equity investment you’re selling some fraction of your company… wouldn’t it be great to be able to buy it back later? Sounds like a great idea!

But it’s a bad idea, for the following reasons:

1. It will invalidate the investor’s SEIS/EIS
   Under the rules for the Seed Enterprise Investment Scheme (SEIS) and Enterprise Investment Scheme (EIS), any ‘pre-arranged exit’ – that is, a pre-arranged right to buy out an investor, or for an investor to sell their shares later – will invalidate the  investment for SEIS/EIS.
2. You can’t use EIS money to buy out existing investors
   Even if future investors didn’t mind you using their funds to buy out existing investors, the HMRC qualifying business activity rules make it clear that EIS investment can only be used for growth, not to buy out existing shareholders. So if you were planning to use the next funding proceeds to buy out existing shareholders, those investments won’t qualify for EIS.
3. It could trigger a withdrawal or reduction of EIS relief
   As well as points 1 and 2, EIS relief could be reduced if your company redeems or repurchases shares from an investor before the end of ‘Period C‘ if your company buys out the investor using EIS investment or otherwise. What if the investment is SEIS? There’s no indication in the relevant legislation or HMRC guidance that the rule applies to SEIS but you should ask HMRC or speak to a tax expert to check before you buy out the investor.
4. The company might not have the money
   Many founders are overly optimistic about the company becoming profitable. The reality is that companies will typically do several rounds of fundraising before generating enough revenue that further fundraising isn’t needed… and it makes no sense to be using company money to buy out investors, only to then have to go out and raise more.
5. It will put off future investors
   Investors invest in a company to grow the business, not to pay off previous investors. If new investors see that you intend to use their funds to buy out existing investors, they might walk away or insist on adding provisions that prevent you from doing so.
6. No smart investor would go for such an arrangement
   This one’s probably the clincher: Why would an investor want to enter into such an arrangement? Investors know that investing in a startup is risky. They know they’re going to be diluted in future rounds. So why do they invest? Because of the upside – the hope that they could get a 10X or, if they’re super lucky, a 50X return on their investment. If you tell them that you want the right to buy back their investment at, say, a 3X multiple later, you take away all their upside, so they’re better off investing any other startup out there, which won’t try to limit their upside.

In summary, it sounds like a good idea that you raise investment now and then one day you’ll buy out your investors to own 100% of the company again. In most cases however, this is a bad idea.

Should you give investors the right to sell their shares?

In the section above, we looked at the founders asking for the right to buy out their investors later. Here we look at investors asking for the right to sell their shares later.

This sounds innocuous… why shouldn’t you give the investor a right to sell their shares…?

So, that’s our cue to examine the difference between an ability and a right:

1. Investors always have the ability to sell their shares… if they can find a buyer and assuming the Articles of Association don’t restrict their ability to sell.
2. If the investor has a right to sell their shares, that means the company is obligated to find a buyer, or be the buyer.

In scenario 1, of course the company can make introductions to potential buyers and generally help a selling shareholder to find a buyer. But it has no obligation to buy the shares itself.

In scenario 2, if the investor has a right to sell their shares, it’s called a put option. The question is: who do they sell the shares to? The company can’t compel anyone to buy those shares, which leaves the company with the obligation to buy the shares itself.

And that’s a huge problem for all the reasons outlined above.

But it’s worse than that, because at least in the scenario of ‘the company has the right to buy out the investors later’, if the company doesn’t have the money they can simply not buy the shares. But in the scenario of ‘the investor has the right to sell their shares’, the company is obligated to buy the shares – if the company doesn’t have the money, this could bankrupt the company. Or the company might be in breach of contract because it’s unable to fulfil the obligation, for example due to the strict rules that apply whenever a company wants to buy back its own shares from a shareholder.

In summary, if an investor asks for a Put Option to sell their shares later, explain to them why you won’t enter into such an arrangement, for all the reasons listed above.

What’s the £1 put option?

There’s one interesting variation of the put option described above: an investor asks for the right to sell their shares for £1. Why would an investor want to lose their entire investment by asking for the right to sell all their shares for just £1?

Well, it turns out some funds have mandates that only allow them to invest in companies with specific activities, for example: positive social impact or tackling climate change. Or companies that don’t sell arms and munitions (it might sound like an extreme example but we’ve seen at least one VC with this restriction in their mandate). Or they won’t invest in companies that might tarnish their reputation.

So if the company they’ve invested in pivots to become the next Only Fans, the investors want the right to just get out by dumping all their shares for £1.

If you see this in the term sheet from your investor it’s probably fine – although you’ll need to read through the wording carefully to make sure your company doesn’t fall into the pitfalls described above. You should ask an independent lawyer to review the wording before agreeing to it – for example, to make sure it works with the strict rules about share buybacks.

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Disclaimer
SeedLegals does not provide legal, tax, accounting or financial advice. We provide information and access to industry standard documents, which should not be used as a substitute for qualified legal, tax or accounting advice. See our Terms for more.