As in, offer a price to buy me out - but you have to be willing to accept the same price for your share (which is the incentive to make a fair offer). Ofc i've only seen it in 2 person partnerships but imagine can be generalised.
Then if one person has $27,000 in their private bank account and the other person has $14,000 then the person with $27,000 can offer $14,001 and the person with $14,000 is forced to accept.
If one of the parties happens to be overdrawn on that account and have net -$3.70 then the other party can ofer $5 and the overdrawn party would be forced to accept.
Now granted in the real world people can raise buyout capital from their private network on short notice -- but doesn't this show great unfairness, if the parties aren't both independently much richer than the value of the business they're discussing?
For most startup founders who own, say, 50% of a startup whose last valuation was $7 million, that is nearly all of their net worth. The vast majority probably could not so much as raise $50,000 on short notice. So, if one of the parties already has a hundred thousand, they can offer $55,000 and the more cash-strapped party would be forced to accept it.
So what gives. I just don't get it at all. Like, I don't even get the theory of why this is supposed to be fair... it just seems "obviously" broken to me -- so I must be missing something.
If the shares are worth $3.5 million, how much do you think the guy leaving can raise on short notice? If you say anything over $100,000 you are delusional.
Investors don't even see the value in companies that are provably worth $1 billion. Even in retrospect you say, "well yeah history showed it is worth $1 billion, and the founder made a good case for that, but actually that is like a founder making a good case that he will role 10 "6's" in a row on a die, and then proceed to do that. The chances that he was going to do that are actually just 1 in 60,466,176 so the correct value of that "$1 billion" share is actually $1 billion / 60,466,176 = $16. That seems a little low - I'll give you a $100 for it. That's my annual budget for lottery tickets."
Investors don't value startups correctly and the idea that a guy can quickly raise money for a buyout of a stake in a company he's leaving borders on delusional. Plus, who would invest in a company with a negative signal that strong: that a guy who owns 1/3 of it wants to leave it.
There is obviously absolutely no way for a cash-poor founder without prior exits to raise anywhere near $3.5 million for a 50% buyout of a company raising a round at $7 million.
honestly - have you tried raising money around the seed stage? It's brutal, if everyone is on board and there are no negative signals of any kind.
I wouldn't be surprised if no poorly networked, cash-poor founder has raised significant (>$1 million) for a shotgun buyout of a company he's leaving, on short notice, ever. I might be wrong though, and I'd love to know if so. In my model it's really, really hard to raise money.
If you cannot raise (with e.g. 20% discount for the trouble), the valuation is wrong.
As a result the poor founder will not be given a fair offer. Which is why I don't get how shotgun clauses are supposed to be fair. This is pretty "obvious" to me. So I might still be missing something.
I say that the situation you described is so far fetched as to be irrelevant to a discussion of "shutgun buyouts" in general.
How did the company reach a $7M valuation? They might have sold 1 share out of 7M shares for $1. That, technically, would make it worth $7M. But practically, it isn't.
Let's say company raised $3M at $4M pre-money => $7M post money. That's not unreasonable. At this point in time, the company has $3M in the bank, so it is indeed worth at least $3M.
Let's say "cash poor founder" only has $100K in the bank. If "cash rich founder" offers to buy 50% for $500K (five times what "cash poor founder" can afford), then it is extremely easy to raise $500K, for a promise to pay $550K from company coffers the next day, because in fact those $500K will buy control of $3M.
And that's exactly why investors insist on vesting schedules, first rights of refusals, tag-alongs, bring-alongs, etc - because the investor who put $3M into that company is likely to lose it in a variety of real world cases without those clauses.
I say your cases are not impossible, just extremely improbable. In practice, it is easy to borrow against a grounded valuation with some.
The poor founder will likely get an "unfair" offer, but "unfair" here is within 10-20% of a fair offer, not a 50% or 90% as in your examples.
I assume poor founder is a smart founder, of course - he might not have access to lenders/investors, which could get him treated unfairly; But of course, that's also the case for having illness, immigration problems, disability, etc. Money is an advantage, lack of money is a disadvantage -- but it is not fatal in these cases in general.
1. Why do you say cash-rich founder's offer of $500K is within 10%-20% of the market price of the shares, when in fact the market has just priced the company at $7M, half of which the market has therefore just priced at $3.5M? It seems to me that $500k is 1/7th of $3.5M, so the offer is only 14% of a fair offer...
For example, what if one partner is greedy and wants to buy out the less greedy, but also poorer, technical founder, after they have some huge windfall that gives huge value to the company. (Some of which is reflected in the $7M valuation they've received - which is not at all low.)
2. You write "that's exactly why investors insist on vesting schedules, first rights of refusals, tag-alongs, bring-alongs, etc". Would you say under the typical clauses offered by VC's, they would allow the remaining founder to spend an unexpected and large amount of money from the company coffers in order to buy out the other partner? (Or repay a debt investment they had raised to do so)? Why would the investors allow that? Especially if it was not envisioned explicitly under "use of funds" and, of course, they'd rather have two partners work on it than one. (But the greedy, cash-rich funder would prefer to own and have the company by himself.)
3. You write - "he might not have access to lenders/investors, which could get him treated unfairly". Would the company be able to raise debt to finance a buyout of one partner by the other or is that not something a company can raise debt for?
Thanks for your answers. I'm pretty shocked at everything you've said. (As you noted at the top of your comment, I misinterpreted you also.) By the way, this does not apply to a situation I am in - and I hope won't apply in the future. I simply do not really understand the clause and its implications in the real world, that well. Thanks for your help.
- founders "Rich" and "Poor" have 50%/50% split, with zero investment so far.
- they raise $3M at a $4M pre-money valuation. This is highly unusual for a "seed"/"pre-seed" stage, but not unusual if they already managed to bootstrap, have paying customers, etc.
- cap table is now: 3/7=~42% investor, 2/7=~28% Rich. 2/7=~28% Poor. (This is your first mistake: poor's stake in the company is worth $3.5M but rather $2M, on paper), and his 28% actually controls ~$850K of cash (assuming perfect democratic voting rights).
1. I am not saying that. I am saying that if the rich founder makes a $500K offer (5 times what the poor founder can afford), the poor founder will easily raise those $500K, because they control about three times as much in voting power. Any offer significantly below $3M * (4/7 * 50%) =~ $850K, e.g. $500K, means that one can raise $500K, and "buy 850K" with it. So the offer, even by rich dude, is guaranteed to not be below $850K. If the company has tangible measurable business, and the real worth is indeed $2M, then the same would be true for any offer significantly less than $2M.
2. Not, they would not. They might buy the founder out themselves, perhaps through the company, but they would not give a carte blanche for that.
3. It is possible to raise money for that, but it would usually be in the form of bonds or loans (essentially different mechanics for the same principle), not in the form of equity.
Discussion of pre-money valuation
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I don't understand why you continually use the pre-money valuation for how much a stake is worth! Usually post-money is used, isn't it?
This is how I think about it - tell me if I'm wrong: let us see if pre-money or post-money is the more appropriate metric, by looking at the extremes. You create a machine that poops bars of gold and show me. I want to buy 99.9% of your company for a billion dollars. You say okay, because you want to go invent something else using a billion dollars, and anyway you're pretty sure I can grow it to a seven hundred billion commodities company, which will make your remaining stake - which might come with anti-dilusion or ratchet clauses, so you always have 0.1% of the company - worth a further $700M. And the rich guy takes all the risk regarding whether he can actually grow it to $700M or fucks it up. You have your $1 billion today, either way, and obviously anyone who can invent a machine that poops bars of gold has good R&D ideas for how to use $1 billion. So you agree.
Ground condition: you had owned 100% of the company. A $1b investment for 99.9% of the company implies a post-money valuation of (1/99.9%) * 1 billion = $1,001,001,001. It implies a pre-money valuation of $1,001,001,001 - $1B = $1,001,001.
So how is the $1M relevant in anyway?
If the pre-money valuation is $1M then would the founder who just accepted $1B for 99.9% of the company, also accept a 50% buyout of the company for $2 million? After all, it's TWICE the pre-money valuation offer he just received!
Of course faced with two options - a 99.9% buyout of the company for $1 billion or a 50% buyout of the company for $2 million, he would accept the first one and not the second one, which to any reasonable person values the company at a much lower value.
As an even more extreme example, if the $2 million were for 100% of the company, then any reasonable person would understand that that offer values the company at $2 million. But the pre-money valuation is $0.
Which also OBVIOUSLY doesn't make any sense whatsoever. How does a 100% buyout offer of $2 million value a company at zero? Obviously it doesn't.
Would a guy looking at a 99.9% buyout for $1 billion and a 50% buyout for $2 million consider the second one to have a higher valuation? Of course not. But the pre-money valuation of the first one is just $1 million and the second one is $2 million - twice as high.
So we have three examples of absurd results from using pre-money valuation.
1. A hundred billion dollar investment for 99.9999999% of the company values the company at $100 pre-money ((1/99.9999999%) * (100,000,000,000) - 100,000,000,000 = $100). This is absurd.
2. A 100% buy of any company at any price values the company at $0. This is absurd.
3. A $4 million valuation (50% for $2m) can value the company higher than a $1 billion valuation - as long as the pre-money of the latter is lower. Again, absurd.
All of these absurd results make it totally unrealistic to use pre-money valuations so I really don't understand why you're doing it! Please explain in detail, as I've been used to using post-money valuations to talk about the value of a company. I thought this was standard.
Maybe I've grossly misunderstood something, so it would be very useful if you told me what!
Your other answers
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Your answer number 2 essentially means these kinds of clauses are only possible where there is not a VC on board, (because if there were, they wouldn't allow it and have protections against it in their standard docs), right?
You gave a partial answer to number 3 ("yes, but it would usually be in the form of bonds or loans") but as a practical matter would banks loan money to a company (say, against its assets as collateral) that was explaining to its loan officer at the bank that it was borrowing money to buy out one partner through another? At a practical level I didn't get whether this is something the company would probably be successful doing or probably fail doing. I have no experience with this. So I am asking whether banks would agree to that.
Thank you for all of your answers by the way! I am particularly interested in your list of reasons for using pre-money. It doesn't seem useful for me, or match people's intuitive definitions of valuation.
Don't take this as a personal attack: To me it seems you are very confused about the difference between share purchase and investment (these are NOT the same thing). In the world of company founding and funding, these go hand in hand with other things like dilution, vesting, rights of first refusal, "double dipping", and many more (and you practically need to be familiar with them to understand why things work the way they do; other wise, things that are very logical and pragmatic like shotgun buyouts don't make much sense).
I don't have the time to give you an answer all of these cases, but when you read on it, keep in mind that EVERY DEAL has both a pre-money valuation and post-money valuation, and the difference between them is exactly the money invested (in a "standard" investment deal). It is important to qualify a valuation (whether pre- or post- money) when you discuss it.
I did NOT use one or other valuation; I gave both, to make the numbers clear.
Again, until you properly understand the difference between share sales and share issuance (which is what is done in an investment), nothing will make sense. Make sure you have a good grasp of these -- a reasonable test if you got it right is to see if my "ground truth" example makes sense.
Thank you for the rest of your comment as well (not taken as a personal attack): I think you have identified one source of my confusion. I closely relate the idea of valuation to share price.
I will read up to get a fuller understanding, but could I just ask one question before you go: do the terms "pre-money valuation" and "post-money valuation" or does the term "valuation", mean anything when you buy 100% of the company from me (without issuing any extra shares shares, and the company doesn't get any of your money) for a certain amount? If that amount is $500,000 then what is the pre-money and post-money valuation (if these terms apply).
This should clear up my confusion as in this case no extra stock is issued. I will read up on the rest. I want to know if these terms (pre-money valuation; post-money valuation; valuation) even apply in such a case!
Thank you for taking the time to understand some of my sources of confusion. Other than this one, I'll try to get a handle on the rest of my questions from other sources.
For a buyout, you usually talk about price (although some people talk about "valuation" in this context too -- nomenclature is not completely standard here).
Not necessarily - for example, in my own company's case, the company itself paid out the other partners. The company can take on debt to buy out a partner's shares (or a portion thereof) if the existing partners are willing.
I couldn't have afforded to buy out my partners personally, but with the business's assets, I could.