Demystifying the VC term sheet: Redemption rights

(Editor’s note: Scott Edward Walker is the founder and CEO of Walker Corporate Law Group, PLLC, a law firm specializing in the representation of entrepreneurs. He submitted this column to VentureBeat.)

For the past few months, I’ve been exploring some of the more confusing terminology in VC term sheets.  In my last post, I discussed conversion provisions, which address the right (or obligation) of the investors to convert their shares of preferred stock into shares of common stock.  Today, I examine redemption rights of the investors.

What are redemption rights?  A redemption right is another feature of preferred stock. It lets investors require the company to repurchase their shares after a specified period of time. In essence, it’s 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 percent of the Bay area deals during the first quarter of 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, only agree if those rights cannot be exercised until at least five years after the closing.  Founders should also try to limit the redemption price to an amount that is 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, which gives investors 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.

(Missed previous installments in this ongoing series?  Click to learn more about the following issues:)

• dividends
• price-based anti-dilution provisions
• exploding term sheets and no shop provisions
• valuation
• liquidation preferences
• stock options
• Board control
• protective provisions
• drag-along rights
• pay to play provisions
• conversion rights

Startup owners: Got a legal question about your business? Submit it in the comments below or email Scott directly. It could end up in an upcoming “Ask the Attorney” column.

Disclaimer: This “Ask the Attorney” post discusses general legal issues, but it does not constitute legal advice in any respect.  No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel in the relevant jurisdiction.  VentureBeat, the author and the author’s firm expressly disclaim all liability in respect of any actions taken or not taken based on any contents of this post.