Today we’ll continue our series on key term sheet provisions by discussing redemption rights.
What Are Redemption Rights?
Redemption rights provisions give investors a future right to have stock repurchased at the original purchase price plus declared and unpaid dividends. The provision can be drafted to provide for mandatory redemption or redemption at the investor’s option.
Generally the right doesn’t mature for at least 5 years, and the redemption payments are spread out over multiple years.
A recent survey indicates that only about one in five venture financings include terms providing for redemption rights.
What is the Rationale for Redemption Rights?
Investors like redemption rights because they provide an alternative exit. If the company is neither collapsing nor rising quickly enough to be an acquisition target by a more mature company, redemption rights give investors an out. This exit strategy can be of some importance to investors because many venture capital funds are set up to operate in 10 year windows. However, most companies that aren’t an acquisition target don’t have enough cash on hand to be able to return investors their original investment. Thus, redemption rights are generally not exercised. The most likely practical effect of redemption rights is that they will be used by investors as leverage to force an acquisition or public offering.
Issues for Founders to Watch Out For
There are a number of issues founders should watch out for when it comes to redemption rights:
- Founders should avoid redemption rights that become mature upon a “material adverse change.” Some redemption rights provisions enable investors to accelerate their redemption rights if the company experiences a material adverse change. This is a vague and subjective standard that founders should always avoid.
- Founders should make sure there is a substantial length of time before the redemption rights mature. Founders want to make sure that they have a meaningful length of time to put the investment capital to good use.
- Founders should make sure the payout on redemption rights is spread out over multiple years. Repaying the investment capital will be burdensome and the longer the period the company has to repay the investment, the better it is for the company.
- Founders should also make sure that the penalty for failure to make redemption payments is not overly harsh. An appropriate interest rate will suffice in most scenarios; founders should avoid agreeing to penalties which permit the investors to appoint all the directors.
- Last, founders should keep in mind that mandatory redemption rights can effect a company’s balance sheet.