4. Redemption Right

So far, we have discussed two ways for the VC to secure preferred returns:

  • Dividend terms
  • Liquidation preference.

The third instrument that is usually put in place (though rarely used) is the Redemption Right. The redemption right is a simple yet very powerful tool. It allows the investors to force the company to repurchase their shares! 

The section on redemption rights in the term sheet usually reads as follows:

  

Redemption Rights:

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)].

   

The general terms of the redemption rights are therefore as follows:

  • The redemption rights can usually not be triggered until at least 5 - 8 years after the financing round.
  • Usually, a majority of the shareholders of the respective class (e.g., Series A Preferred) has to agree to trigger redemption.
  • Usually, the redemption value is set equal to the original purchase price (possibly plus accrued dividends).

 

The overwhelming majority of all VC deals (>90%) grant the investors with a redemption right. The main purpose is to avoid lifestyle or walking dead companies, i.e., companies that generate sufficient money to stay alive but not enough to offer a clear alternative path to exit for the financial investors.

If the company cannot redeem the shares because of insufficient liquidity, there are typically penalties such as the reduction of the investor's conversion price or higher board representation.

Because the redemption right is one possible path of exit for the investors, we will get back to it in the section on Exit Provisions (Liquidity).