This post is the ninth in a series giving practical advice to startups with respect to understanding and negotiating a venture capital term sheet.
In the prior eight posts, we provided an introduction to negotiation of the term sheet and discussed binding and non-binding provisions, discussed valuation, cap tables, and the price per share, discussed dividends on preferred stock, explained how liquidation preferences work, discussed the conversion rights and features of preferred stock, examined voting rights and investor protection provisions, analyzed anti-dilution provisions, and looked at anti-dilution carve-outs and “pay to play” provisions. This post will discuss redemption rights.
The NVCA model term includes a redemption rights provision. A typical redemption rights provision provides that a certain percentage of the preferred stockholders can vote after a certain length of time has passed (five years is common), to cause the company to redeem all shares of the preferred stock for its original purchase price and possibly accrued and unpaid dividends. It thus functions as a put right. The redemption price can also be keyed to another measure, such as the fair market value of the stock at the time of redemption, but this is less common and should be resisted by founders. The redemption price can be required to be paid in a lump sum or in installments over some period of time.
Redemption rights will be limited by any applicable state law governing distributions to stockholders. That is, a corporation may generally not redeem shares when the payment would cause the corporation to be insolvent.
A redemption right appears to be, on its face, an exit option for investors. However, in practice, such redemption rights are rarely exercised. Remember the reason venture capitalists choose to invest in a given company — they are not hoping to merely recoup their investment, but rather looking for a big payoff — and within a short time frame, as VC funds generally have a limited life. This usually comes in the form of a sale of the company or an initial public offering. Investors usually won’t want to get out of the game entirely if they are only getting a return of their original investment and maybe dividends.
However, there are scenarios in which venture capital investors might want to cut their losses, regain their investment, and look elsewhere. For example, if a company is hobbling along, not doing too badly but not growing either — what many refer to as a “sideways situation” — neither a sale nor an IPO are likely. Or perhaps if the investors think the company is tanking. These are both scenarios where investors may want to exercise (or at least threaten to exercise) their put rights, which could cripple a company needing cash.
Another thing redemption rights can do for venture capital investors is give them some leverage over the company during the period when redemption rights are exercisable. For example, the NVCA term sheet points out that venture capital investors may try to include provisions giving them extraordinary powers such as electing a majority of directors or the right to consent to cash expenditures until the redemption price is paid in full.
Founders should be aware that venture capital investors may expect the term sheet to include redemption rights. And while redemption rights are infrequently exercised, they should be thoroughly considered. Founders should beware in particular of any provisions that give investors the right to a price greater than their original investment or that trigger the redemption right early or under unusual conditions, as well as any burdensome provisions that would apply when redemption rights are exercisable.
In the next post, we’ll discuss registration rights.
This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.
