What are redemption rights?
July 11, 2007
A redemption right is the right of the investors to force a company to repurchase their shares. According to the WSGR survey of private company financing trends from 2005 through Q1 2007, redemption rights were included in about one third of venture financings. As a practical matter, redemption rights, like demand registration rights, are almost never exercised. If the company is doing so poorly that the investors want their money back, there probably isn’t any money left to redeem the shares. However, the threat of redemption is probably helpful to provide investors with leverage against “walking dead” portfolio companies that generate enough revenue to stay alive in a niche market, but haven’t grown enough to be interesting M&A or IPO candidate.
Due to restrictions under Delaware (and other state corporate law), a company might not be legally permitted to redeem shares. In this case, investors may request that certain penalty provisions take effect where redemption has been requested but the company’s does not have enough funds to permit redemption or redemption would leave the company legally insolvent. These penalty provisions may include the redemption amount being paid via a promissory note and/or the investors being allowed to elect a majority of the board of directors until the redemption price is paid in full.
The principal variables in the redemption right are when the right is triggered and the redemption price. Most redemption rights are set so they cannot be triggered until at least 5 years after the Series A financing. This is because a company needs a sufficient amount of time to achieve results, while a venture fund needs to be able to liquidate an investment at the end of life a fund. The redemption price is typically the original purchase price plus accrued but unpaid dividends. In “East Coast” investor-friendly deals, the investors may try to add cumulative dividends to the redemption price, which essentially gives the investor a guaranteed 8%+ rate of return, assuming of course, that there is cash available for redemption. The redemption may be triggered by a majority or super-majority vote of investors. Some investors may be allowed to opt out of the redemption or the redemption provision may require all shares to be redeemed. The redemption may occur in multiple installments over one to three years.