Starting a company with co-founders is a lot like forming a band. You choose your co-founders because you all share a vision, you’re excited to build something together, and you hope the team sticks around for the world tour.
But inevitably, reality sets in. Just like rock bands, founding teams often change. Someone steps back, priorities shift, and suddenly you’re facing a common but tricky issue: “dead equity”, shares held by a founder who’s no longer in actively working in the business, no longer helping drive the company forward.
This happens more often than founders expect, and it’s rarely simple to fix. Many founders are blindsided by the legal and financial implications, and even sophisticated investors can grow uneasy if it’s not addressed early and efficiently.
Rebalancing the cap table when a founder leaves requires careful planning, open communication, and a solid understanding of the tools available. Here’s how to keep your cap table healthy, your investors happy, and your company on track when the lineup changes.
Why Dead Equity Is a Problem
Dead equity means a significant chunk of your company is owned by someone who’s no longer contributing/working in the business. Venture capitalists rightly see this dead equity as a problem, founders who are still building the company resent the dead equity, and when dead equity shows up in your cap table, that dead equity can tank your fundraising efforts. Generally, VCs take issue when 10% or more of the company is dead capital—especially when that’s more than what an active founder owns.
Face the Music: Open the Conversation
Startups are built on trust. When a founder steps away, start with an honest conversation about the impact on the cap table. Don’t avoid this conversation. If you’re lucky, your departing founder will understand why rebalancing the equity is necessary. If not, you’ll need to explain that without a fix, future funding/the future of the company is at risk.
Know Your Options
If the founder who’s leaving isn’t open to rebalancing the equity—code for giving up some of that dead equity voluntarily, then the company may need to think how to recapitalize the cap table. There’s no one-size-fits-all solution to ‘fix’ the cap table of dead equity, but here are the most practical approaches:
A. Secondary Sale to Investors: Have your lead VC or new investor buy shares directly from the departing founder. This approach is clean and straightforward. The VC gets to their target ownership (usually, around 10%), the departing founder gets some liquidity, and you avoid diluting everyone else. Just be sure to convert the departing founder’s common shares to preferred shares as part of the round, so the investor’s rights are aligned.
These days, VCs expect a small secondary (often up to 10% of the round) for founder liquidity. Frame this as an alignment initiative, not a cleanup. While secondaries are most common in priced rounds, they also occur outside of that context—for example, as part of strategic cleanup before a Simple Agreement for Future Equity (SAFE) or convertible note round, or during a management transition. Handled properly, a secondary can defuse future cap table concerns and help a new investor step in with confidence.
The key issue for a secondary is at what price the departing founder’s common shares should be bought. Generally, companies prepare 409A valuations once a year. A starting point is to “discount” the founder’s common shares by the discount reflected in the 409A valuation. The reality is usually some back-and-forth before the secondary buyer and the departing founder agree on a price per share.
B. Company Buyback or Share Transfer: Sometimes the company buys back the shares, or the remaining founders step in to purchase them. It sounds simple—but it can get messy, fast. Between valuation issues, tax exposure, and corporate law constraints, buybacks and share transfers often carry more complexity than founders anticipate.
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- Tax Traps: If you buy shares below Fair Market Value (FMV), the IRS treats the difference as taxable income. If you use a company loan, you risk running afoul of Section 409A, and imputed interest applies. To mitigate this, use a recent 409A valuation or independent appraisal to set the purchase price. If the company is funding the buyback, make sure there’s enough surplus under Delaware law to do it legally.
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- QSBS Risk: Qualified Small Business Stock (QSBS) benefits only apply to original issuances. Transfers between founders or repurchases can kill QSBS eligibility for everyone if not handled carefully. A poorly structured transfer can reset the QSBS holding period or disqualify the shares entirely, depending on timing and whether the company still qualifies. It’s critical to consult with your tax advisors before repurchasing any shares that founders believe may qualify for the QSBS exclusion under Section 1202.
C. Option Pool Expansion: Instead of moving shares around, expand the option pool. Grant more options to the remaining team and new hires. Negotiate with investors to calculate their ownership after the pool expansion-don’t fall for the ‘pre-pool’ trap. This keeps incentives aligned without complicated transfers. It’s often the cleanest fix when the founder won’t sell, or when there’s no cash to support a buyback. Investors usually accept it, provided it’s paired with a clear hiring or retention plan that justifies the increased pool.
D. Deferred Shares or Recapitalization: In some cases, converting the departing founder’s shares into deferred shares or even recapitalizing the company can reset the cap table. This is more drastic and usually only makes sense if the cap table is truly broken. These moves usually require amending the charter and getting full board and stockholder approval—so alignment and leverage really matter. One approach is to convert the founder’s shares to a new class with no voting or economic rights, but a potential earnout if certain milestones are met.
Don’t Ignore Tax and Legal Landmines
Every cap table fix comes with tax and legal consequences, some of them easy to overlook. Before finalizing any changes, make sure you’ve covered the basics:
- QSBS Compliance: Confirm the original issuance met Section 1202 requirements. One defective certificate can invalidate QSBS for everyone. Even if the company qualifies as a Qualified Small Business, founders must hold their shares for at least five years to claim the capital gains exclusion under Section 1202. Transfers or buybacks—especially if poorly structured—can reset the holding period or disqualify the shares entirely.
- FMV: Transfers must be at FMV to avoid tax headaches. The IRS may treat a below-FMV transfer as compensation, triggering ordinary income tax for the seller and possible withholding obligations for the company. Relying on a recent 409A valuation or independent third-party appraisal is usually the best way to support pricing.
- Investor Expectations: Be transparent. Loop in your investors early and make sure they’re aligned with the plan. Institutional investors will often want to review cap table changes before a priced round or significant SAFE raise. Hiding a buyback or transfer, even unintentionally, can derail a term sheet or push back a close.
Play the Long Game
If the departing founder isn’t ready to sell, create a roadmap for a future secondary. Revisit the conversation once you’ve hit a major milestone, like a Series B or a late Series A extension. With more traction and a higher valuation, people tend to get more flexible.
In the meantime, consider negotiating a call option or a right of first refusal (ROFR) that allows the company or its investors to repurchase the shares under predefined terms. You can build these rights into the Stockholders’ Agreement or a Side Letter—giving the company a clean option later without forcing a decision too soon.
Keep the Band Playing
Losing a founder is hard—but it doesn’t have to throw the whole company off track. When handled thoughtfully, a transition can strengthen the business and set it up for long-term success. Here’s what helps founders get through it cleanly and come out stronger:
- Keep the conversation open, honest, and focused on the company’s future.
- Prioritize solutions that are clean, fair, and minimize tax risk.
- Always, always consult legal and tax advisors before pulling the trigger.
At PAG Law, we’ve seen every version of the “band breakup.” We help founders rebalance their cap tables, keep investors engaged, and avoid the legal and tax traps that can derail a great company. If you’re facing a cap table headache, let’s talk. The band may change, but the show must go on. Don’t let dead equity stop you from playing your next gig/next round.
