Ask a MoFo: Common Provisions in Venture Capital Term Sheets: Redemption Rights

This article is one in a series of articles explaining various terms commonly seen in venture capital equity financings, keyed to the commonly referenced National Venture Capital Association (NVCA) documents. We encourage you to submit questions you would like to see answered as part of this series to ECVCevents@mofo.com.

What Are Redemption Rights?

If a founder is reviewing a term sheet received from a venture capital investor, he or she may raise eyebrows upon seeing “redemption rights” in the term sheet. A redemption right is a right held by investors that, under certain conditions, would force a company to repurchase the preferred shares previously sold to investors. In other words, the venture capital investor is proposing an investment in your company while at the same time reserving the right to be “bought out” or “redeemed” if things don’t go as planned. In this article, we will go over the basics of redemption rights, including their costs and benefits from the perspectives of the parties.   

How Do Redemption Rights Work?

Redemption rights can be mandatory, but more frequently they are optional at the discretion of the investors. A mandatory redemption right requires the company to repurchase stock from the investors automatically if certain specified conditions are met. An optional redemption right requires the company to redeem the preferred stock if a majority or super-majority of the preferred stockholders vote for redemption (also contingent upon certain other specified conditions having been met). Frequently, the investors are offered the ability to opt-out of an optional redemption if they would like to remain stockholders.

As noted above, these rights are triggered by certain predefined conditions. In some instances, it can be as simple as a number of years having elapsed, and in others, the trigger may be the failure of some regulatory approval or breach of the company’s covenants to the investors, or some combination of all of these. 

After the event and/or votes have occurred, the company is required to buy back the shares in one or more installments within a set period of time. The buyback is done either at a predetermined price or based on a formula. Frequently, the redemption price is the price that the investor bought the stock for plus any accrued but unpaid dividends, or the fair market value of the shares at the time of redemption.

Impact of Redemption Rights

At the most basic level, redemption rights require companies to operate with an eye on the potential obligation to give their investors back their money. This can complicate the analysis when companies are considering their burn rates and cash-out dates.

In practice, companies that investors want to get out of early are unlikely to be in the position to readily pay back these obligations. If a company is facing a redemption threat or demand, the parties will need to evaluate whether the redemption is permissible under Delaware law and the impacts that the event will have on the company as a going concern as well as its tax ramifications.

That being said, investors may be asking for redemption rights for a variety of reasons. Most frequently, the investors are either looking to de-risk their investment by having a route to recouping their capital if things don’t go as planned or are wanting a forcing mechanism to encourage the company to exit within a set period of time.

While investors may negotiate for the inclusion of redemption rights as a condition to a financing, such rights are rarely invoked in practice, but they can nevertheless be used as investor leverage to implement operational and/or structural changes.  

Final Thoughts

In U.S. venture financings, redemption rights are rare with moderately increased use in later stage financings where the investor profile may not be traditional venture capital investors. These can be some of the more complicated provisions to negotiate, and deservedly so, given that they can put the company into a distressed situation. When redemption rights are raised, it is important to work with counsel to structure these provisions appropriately and consider whether alternatives may better suit the needs of the parties.