Generally, a company receives venture capital (VC) money via an investment round, the company issues preferred stock to the VC investor. The terms of the preferred stock vary significantly from deal to deal, but generally preferred stock includes a number of rights, including redemption rights (also called “put” rights). If you are considering granting redemption rights to investors or if you are considering investing in a startup, it may be helpful to discuss the implications with a financing lawyer from the Priori network.
Understanding Redemption Rights
Redemption rights grant investors the right to force the company to purchase back its shares in certain specified instances and during certain specified instances. In essence, redemption rights give investors a put option to sell back shares in certain enumerated situations.
Like any put option, the purchase price when exercised is also set in advance. In some cases, the purchase price is simply set at the original purchase price plus any accrued, unpaid dividends. In other, more investor-friendly, provisions the purchase price is set at the original purchase price plus any accrued, unpaid dividends, plus cumulative dividends, which effectively provides an alternative avenue to realize return on the investment.
Why VC Investors Require Redemption Rights
Redemption rights are an investor protection designed to facilitate an exit when necessary. Redemption rights facilitate an exit in two possible scenarios. First, redemption rights ensure that investors do not become saddled with “walking dead” companies, which are companies that are successful enough to operate in a niche market and make a profit, but never gain enough traction to be a candidate for an acquisition or an IPO. Because the company will stay private and is unlikely to be an appealing candidate for another investor, redemption rights provide an out.
Secondly, redemption rights provide an exit for investors who simply run out of time to let the company come into success. Many venture capital funds have limited lifespans -- often ten years. A venture fund manager may need redemption rights to ensure liquidity when the fund winds down, especially if the investment is made after the five-year mark. Because of the possibility of either scenario, some investors will not be willing to provide capital without redemption rights—and the associated promise of a timely exit.
What Redemption Rights Mean for Startups
Redemption rights are rarely exercised by investors. Still, if redemption rights are a feature of the preferred stock issued by a startup, it’s important to know the details of the right, including (i) any limitations on when it may be exercised (i.e. only after five years or in other specified situations); and (ii) whether cumulative dividends are involved.
What is an adverse change redemption clause?
An adverse change redemption clause is a broad redemption right, wherein investors are not limited to exercising redemption rights to after a certain period of time or when others are redeeming shares. Instead, redemption rights can be exercised after any material adverse change to a company’s business, operations, financial position or prospects.
Are redemption rights legal?
Yes, but in some states (including Delaware), forcing a company to redeem shares under certain circumstances may not be permitted if it forces the company into insolvency or otherwise takes an undue financial toll. That’s why many redemption rights are structured in such as way as to allow for such rights only where permitted by law. To this end, clause may include a penalty that is only triggered when a redemption is requested but not possible. Such penalties can include the redemption amount being paid via promissory note or the right to elect a majority of the board of directors until the redemption price is paid in full.