This post originally appeared in the “Ask the Attorney” column I am writing for VentureBeat; it is part of my ongoing series regarding venture capital term sheets. Here are the issues I have addressed to date:
- common mistakes dealing with VC’s
- liquidation preferences
- stock options
- exploding term sheets and no-shop provisions
- anti-dilution provisions
- Board control
- protective provisions
- drag-along provisions
- pay-to-play and pull-up provisions
- conversion rights
In today’s post, I examine the redemption rights of investors.
What Are Redemption Rights? A redemption right is another feature of preferred stock and permits the investors to require the company to repurchase their shares after a specified period of time; it is, in effect, a “put” right – that is, the investors may elect to put their shares back to the company. As a practical matter, however, redemption rights are rarely exercised and, according to Fenwick & West’s recent VC survey, only 20% of the deals in the San Francisco Bay area included such rights.
Redemption rights are principally designed to protect investors from a situation where, after a period of time, their portfolio company is just moving “sideways” and, accordingly, is not an attractive acquisition target or IPO candidate. Investors are thus given the opportunity to exit their investment by exercising their redemption rights – which is particularly important because venture capital funds have limited lives (typically 10 years).
The problem, of course, is that a so-called “walking dead” company rarely has the cash to buy-back the investors’ shares. Moreover, there are significant restrictions under applicable State law regarding redemptions if the company does not have the legally-available capital.
What Does a Redemption Rights Provision Look Like? A redemption rights provision will typically look like this in the term sheet:
“Unless prohibited by [Delaware] law governing distributions to stockholders, the Series A Preferred shall be redeemable at the option of holders of at least [__ ]% of the Series A Preferred commencing any time after the [fifth] anniversary of the Closing, at a price equal to the Original Purchase Price [plus all accrued but unpaid dividends]. Redemption shall occur in [three] equal annual portions. Upon a redemption request from the holders of the required percentage of the Series A Preferred, all Series A Preferred shares shall be redeemed [(except for any Series A holders who affirmatively opt-out)].”
What Are the Key Issues for Founders? There are several issues founders should focus on in connection with redemption rights. First, founders should push back to knock them out entirely because, as noted above, they are not the norm and rarely implemented.
If the investors insist on redemption rights, the founders should only agree if such rights cannot be exercised until at least five years after the closing. Founders should also try to limit the redemption price to an amount equal to the investment — and push back hard on any cumulative dividends.
Investors will sometimes try to add enforcement provisions to give their redemption rights some teeth; for example, the investors may require that if the company defaults (cannot pay the redemption price in cash), then the investors will have the right to elect a majority of the Board of Directors until the redemption price is paid in full and/or the Company will be required to pay the redemption price via the issuance of promissory notes. Again, the founders should push back hard.
Finally, founders should watch-out for unusual redemption rights, such as a “MAC” redemption pursuant to which investors are given the right to redeem their shares if the company “experiences a material adverse change to its business, operations, financial position or prospects.” This is a non-starter.
I hope the foregoing is helpful. If you have any questions, please feel free to call me directly at 310-288-6667 (Los Angeles) or 415-979-9998 (San Francisco). Many thanks, Scott