NOTE: This is the eighth post in our series about standard terms in early stage equity financings. These posts refer to the model Series A Term Sheet put out by the National Venture Capital Association (NVCA) and available for download here.
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The NVCA model term sheet includes a typical Redemption Rights provision entitling investors to require the company to repurchase all of the outstanding shares of stock held by the investors at a certain point in the future (typically five years from the date of a Series A financing, give or take a year or two). The redemption price is typically the original price paid by the investors plus any accrued and unpaid dividends. Exercising Redemption Rights usually requires approval of at least X% of the investors, where the applicable percentage is generally the same as that required to approve actions under the Series A Protective Provisions, though sometimes the presumption is flipped such that redemption is required unless at least X% of the investors waive it (called “mandatory” Redemption Rights).
Redemption Rights are important to investors because they provide an exit in the event the company turns out to be successful enough to survive, but not successful enough to go public or be acquired by the time the investors need liquidity (remember that VC funds have a limited lifespan). In practice, however, Redemption Rights are almost never exercised because even if the company is still around (and has not gone public) when the Redemption Rights mature, it probably does not have sufficient cash available to repurchase the investors’ shares. Investors will often insist that the Charter provide for penalties if the company fails to redeem the investors’ shares when the Redemption Right is exercised – for instance, the conversion ratio may be increased (see our post on Conversion) or the investors may obtain the right to elect a majority of the company’s Board of Directors until all the investors’ shares are redeemed – but even the penalties are sometimes not enforced if the investors believe doing so would only further harm the company’s prospects. The most important impact of the Redemption Rights (and any associated penalties), therefore, is that it gives the investors leverage to extract concessions from the company. For instance, the investors may use the threat of exercising their Redemption Rights to compel reluctant founders to take the company public or accept an acquisition offer.
Redemption Rights are typical in Series A financings (though not in earlier seed financings) and entrepreneurs should focus on minimizing their impact rather than eliminating them altogether. The impact of Redemption Rights can be reduced by (a) pushing for optional rather than mandatory Redemption Rights, (b) lengthening the time before the rights mature (beware of anything in the term sheet that accelerates maturity in certain circumstances, such as a material change in the company’s business), (c) providing that any payout in a redemption is made over a lengthy period of time (preferably at least 3 years) and (d) ensuring that the consequences of failing to redeem the investors’ shares are not too draconian (for instance, where the investors earn interest on the unpaid amounts until redemption while still also accruing dividends on the unredeemed shares).
Finally, it is worth noting that on occasion the company can negotiate for a Redemption Right of its own, entitling it to call (i.e. require the sale back to the company of) the investors’ shares at a future date, though the redemption price will necessarily be higher than for an investor Redemption Right.