The Case Against Personal Founder Guarantees

This blog post will not win me friends at some law firms, and one or the other investor may also frown, but after years of legal practice in venture capital I feel the case is overwhelming: The (mostly European¹) mantra that founders need to be personally liable for the representations and warranties agreed in early-stage funding rounds is counterproductive.

To be clear: I am not saying that representations and warranties as such are useless. When an investor hands over a sizeable amount of money he can expect that “what he sees is what he gets”, even more since not every important matter can be verified during due diligence (for more detail on due diligence and its interaction with contractual guarantees take a look here). But: The guarantees can be given by the company. There is no convincing reason why the founders should (also) be liable with their personal assets.

Most investors and lawyers who demand personal guarantees by the founders make the following arguments:

• If there are problems with the business resulting from the breach of a guarantee, compensation by the company may not be possible for solvency reasons or lead to undesired cash leakage.
• Compensation by the company may not be sufficient.
• Founders will only take the guarantees seriously and think hard about whether they can actually give them if their personal assets are at risk.

While appearing sensible at first sight, none of these arguments holds up upon closer inspection.

If the company is not allowed to pay cash, it can always issue shares

Let’s start with the “impermissibility” and “undesirability” argument. There are indeed solvency rules in most major jurisdictions that prevent the transfer of funds to shareholders if certain minimum capital requirements are no longer met (Germany, in particular, is strict on this front). But these limitations only refer to the transfer of cash/assets, NOT to the issuance of equity. The company can therefore always issue shares instead of paying cash. Alternatively, the damage claim can be suspended until the company becomes sufficiently solvent again. And if cash leakage is a concern, a general right of the company to replace cash compensation with shares may be agreed.

Personal guarantees don’t really help investors

In most cases of early-stage venture investment, founders are young and do not have significant assets besides their salaries and their stake in the company (which investors, of course, don’t have a problem with). Recovering sizeable value from assets OTHER than those sitting within the company is therefore illusionary (and hardly compatible with a productive working relationship — more on this below).

Of course investors who demand personal guarantees know this and for this reason are generally happy to limit the personal liability of founders to, say, a one-year salary. But if this is the case, why bother in the first place? Even if a founder was willing to work “for free” for a year (and take on a second job to finance his living expenses :-)), a typical annual salary in a start-up will hardly make a dent in the damage incurred if there really is a warranty issue. And if the damage is small (but above a materiality threshold which should in any case be agreed), getting into a fight with founders over their personal assets is crazy to even think about: The company will always be able to provide sufficient compensation.

If personal assets are off-limits, wouldn’t it be a sensible compromise to allow founders to cover damages with their shares? Good idea, but then it’s de facto no longer a personal guarantee as the handover of shares by a founder leads to the same result as the issuance of free shares by the company to the investors: In both cases founders give up a certain portion of their shareholding, in the first by direct transfer, in the second indirectly due to dilution. The economic result is the same.

This leaves one — theoretical — scenario, where a personal liability of a founder could reasonably help investors actually recover some value: outright fraud. If for example a founder does not disclose an intellectual property claim filed against the company that prevents it from continuing its business at an acceptable cost, investors may feel entitled to “burn all bridges”, while the issuance of additional shares by the company or transfer of the founder’s shares will not help if the company is worthless. Yet in this case the founder will be personally liable regardless of what has been agreed in the contracts as the liability for fraud or willful intent cannot be excluded or limited as a matter of (legal) principle.

If personal guarantees are needed to motivate a founder, investors shouldn’t invest in the first place

Finally, the argument that personal guarantees are needed to make the guarantee statements trustworthy also does not hold up. The (theoretical) risk of a court order “hanging over a founder” may make a difference theoretically, but in practice it does not: A founder who requires the threat of personal litigation to make him or her diligent and honest will not bring the intrinsic motivation and character required to build a great company (apart from being poorly advised about fraud, see above). In any instance where a personal liability could actually help with honesty, the investor will likely have picked the wrong founder in the first place.

Getting rid of personal guarantees helps all parties

While there is no convincing reason in favor of personal guarantees, there is a very good argument for getting rid of them: It removes a major source of irritation. In venture capital, investors and founders need to cooperate closely to create value. The threat of personal litigation is hardly conducive to a trustful relationship². And where lawyers and treasurers voice reservations about the company’s liability, express rules on cash vs. share compensation (“compensatory capital increase”) and the suspension of (non-equity) claims help with capital maintenance rules and concerns over cash leakage.

Notes

1. In the US market practice is more geared towards founders: Generally only the company is liable (see esp. the NVCA Series A standard).

2. This is also what differentiates venture capital (and in fact most minority investments) from an outright sale (where personal seller guarantees are generally justified): In this case seller(s) and buyer(s) will (mostly) part ways once the transaction is completed, so there is much less need to take heed of the other side’s interests.