A Founder’s Repurchase Dilemma

While serial entrepreneurs may already be immune, or at the very least indifferent, first-timers often have trouble biting the Repurchase Agreement bullet. How did you feel when your investors told you that reverse-vesting provisions were going to apply to shares that were already yours?

From an emotional aspect, Repurchase Agreements can have a detrimental effect on the founders. “We’ll invest in your company, but you’re going to have to give us your shares and get them back only if you stay the term”.

You probably felt insulted, offended, you might have cringed, but ultimately you conceded because your investors persisted and insisted, and since Repurchase Agreements have come to be the (unpleasant) norm, even though everyone knows a carrot can work just as well as, or even better than a stick.

Waive Goodbye

From a practical aspect, Repurchase Agreements are not really effective. When founders jump ship it usually means the boat isn’t worth much, and believe you me those repurchase shares are certainly not going to change that.

And when founders leave a company that has strong prospects, experience tells us the parties work out a deal to replace the Repurchase Agreement.

That may be the reason we’re starting to see more and more investors that are willing to waive the Repurchase Agreement requirement, considering the negative impact such arrangements can cause the investor-founder relationship on day one may well exceed the benefit such arrangement may one day bring.

The (Unpleasant) Tax Consequences

And here’s something you entrepreneurs might want to consider before your next financing round.

While your investors may not have intended for you to get taxed at the highest bracket when selling your shares, the Israel Tax Authority could use the Repurchase Agreement against founders, since the Repurchase Agreement in essence takes shares previously owned free and clear and makes them contingent upon fulfilling certain work obligations.

Thus, it may be argued that income previously categorized as capital gains has transformed into ordinary work income, and your 25% tax rate jumps to 50%.

That Which Makes Sense

As the Repurchase Agreement is solely designed to work as an incentive, it makes sense to me that founders ask for an indemnity clause just in case the Israel Tax Authority brings this up down the road.

In addition to being a fair and reasonable countermeasure, it just might have everybody around the table consider a more reasonable alternative to the odious Repurchase Arrangement.

Ran Dimant is a Founding Partner of Katzenell Dimant and provides strategic and practical legal advice to corporations, institutions and business initiatives, addressing all aspects of their activity.

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