Redemption Rights - Term Sheet Provision
What are Redemption Rights?
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Table of ContentsWhat are Stock Redemption Rights?What are Optional Redemption Rights?What are Mandatory Redemption Rights?Redemptions and Conflicts of Interest
What are Stock Redemption Rights?
Redemption occurs when the company repurchases shares from the companys equity holders. Redemption rights are the rights of the shareholder to force the company to repurchase shares. Redemption rights are generally either mandatory or optional.
- Example: 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 [________] 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)].
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What are Optional Redemption Rights?
Optional (Demand) redemption facilitates the venture capitalists desire to exit a venture when the amount of value created from any additional capital is approximately equal to the amount of new capital invested. It is a foreseeable risk, however, that the firm will not grow and develop sufficiently to return the investors capital (along with any interest or preferred returns) during the projected investment period. A demand redemption right is a strong control provision that minimizes the risk to the investor of becoming stuck in a failing business. The right allows the investor to control the entrepreneurs ability to seek an early exit from the venture, which could result in a failure of the business to meet the investors expectations for returns. At the same time, these rights augment the risk to the entrepreneur that the investor will effectively bankrupt the business by demanding a return of capital through a repurchase or her shares. The right generally involves the entire class of investors. To exercise the right, a majority or super-majority of the class will have to vote for redemption. The investors not seeking redemption may opt out of redemption. The redemption may occur all at once or over a period of time.
Demand redemption rights are present in many stock purchase agreements, but the rights are rarely exercised. The reason is because there is likely little or no money left to return to the shareholder. If the money were returned to the shareholder, it would undoubtedly cause preferential payment issues with debtors of the business, who could easily force involuntary bankruptcy on the startup venture. Investors may attempt to negotiate penalty provisions into the agreement requiring the company to sign a promissory note or give up board control in the event of a failed redemption request. The enforceability of these provisions are questionable and could again give rise to priority issues under state law.
What are Mandatory Redemption Rights?
Mandatory redemption, in contrast to demand reduction, normally occurs at a stated time, upon a specific occurrence, or staggered over a period of time. The questions become, when is the mandatory redemption right triggered and, as with voluntary redemption, what will be the redemption price? The price is generally the purchase price along with any accrued and unpaid dividends (if applicable). Most redemption provisions do not allow for redemption until a sale of the company or at least a set period of time following the financing.
Assuming the company has sufficient assets to do so, if the business has not reached a point where it can sell or otherwise liquidate investor interest, the investor has the right to force the company to redeem some or all of the her shares. While mandatory reduction imputes a level of decision-making by the investor at a given point, it lacks the extensive control afforded by the demand right. While the mandatory redemption provision is a risk allocation provision in favor of the investor, it reduces the level of control of the investor in determining when redemption occurs. The time frame will be reasonable in light of company performance goals and the venture capitalists time from for dissolving the fund.
Redemptions and Conflicts of Interest
These control mechanisms demonstrate a distinct disparity in the intentions of the entrepreneur and the investor. While the entrepreneur seeks to continue the growth of the business, redemptions rights stand to thwart that growth in the event the investor either chooses to exit or the business fails to achieve certain growth goals that call for mandatory redemption. They may also create a risk to entrepreneurs ability to attract future investors, as any future invested funds could be used to redeem the earlier investor rather than for business growth. In reality, the redemption provision is more used as leverage by the investors to force the hands of the directors when the company does not seem to be progressing.