Early share sales by founders make sense under certain conditions

One of our entrepreneurs recently requested to sell some of his personal shares to us. After thinking through the positive and negative consequences of such a share sale which takes place before an exit or funding round, we decided to move forward with the transaction. I’m now going to review our reasoning which produced this outcome. Although most venture capitalists don’t look favorably on the sale of shares by a founder before a funding event, or often even before the ultimate exit, I believe that they should be considered on a case by case basis.

The clear advantage of allowing a founder to sell shares before an exit or funding round is that it provides them with financial flexibility. Since the vast majority of a founder’s wealth is often tied up in the company’s illiquid stock, this can place the founder under external financial pressure. If the founder needs to think about how to make ends meet on a regular basis, this will leave them with less time to concentrate on what ultimately matters, the success of the startup. An early share sale is a simple way to alleviate some of this external financial pressure.

The disadvantage of allowing a founder to engage in an early share sale is that it may serve as a negative signal to third parties, including current and future investors. The founder is almost always the person closest to the company and they therefore have the most insight about the company’s future prospects. If the founder is selling stock, then perhaps current investors should have doubts about the potential upside of the company. Future investors, who have even less information than current investors, may have reason to be hesitant to invest in a new round.

Although these are valid concerns which need to be addressed, I do not believe that the solution requires an outright ban on early share sales by founders. Instead, investors should take reasonable measures to solve the concerns raised by an early share sale. More specifically, this can take place by restricting the magnitude of the share sale to ensure that the founder is still incentivized to make the startup a success after selling their shares, and pursuing the transaction at a discount to the startup’s enterprise value which would have been negotiated in a regular round. Taken together, these two measures limit the negative signaling impact of an early share sale while still allowing the entrepreneur to achieve the financial flexibility necessary to focus only on the success of the business.