2. Redemption Rights

Redemption Rights were already an important topic in the session on the Division of Financial Returns. The basic idea behind redemption rights is very simple. They allow the investors to demand that the company repurchases their preferred stock. 

Some of the typical characteristics of redemption rights are:

  • The amount of redemption typically corresponds to the original purchase price (plus accrued dividends).
  • The right kicks in at the end of the (expected) investment period. Usually, five to eight years after the investment. If the investors exercise their right, redemption is then usually phased over three years (that is, the company can repurchase the shares in three annual instalments).
  • In some cases redemption is triggered automatically, whereas in other cases, a vote of the preferred stockholders is required.
  • If the company does not redeem the shares as required (for example because of insufficient funds), there are usually some control mechanisms triggered that shift more control to the investors (e.g., additional voting rights, majority of board seats, etc.).
  • Redemption usually follows the seniority structure outlined in the section on liquidation preference. Consequently, the default is that later rounds of preferred have senior redemption claims than earlier rounds.

 

Redemption rights therefore give the investors the right to force a liquidity event upon the company. For example, investors could use these rights if the founders do not want to exit or because the business does not develop into a promising exit case (e.g., to conduct an IPO). 

The obvious problem with redemption rights is that if the firm is not an attractive exit case, it will be very hard for the investors to actually capture the redemption value:

  • The companies do generally not have sufficient internal funds or cash flows to finance redemption on their own.
  • If the founders do now want to exit, it will be hard to convince new investors to finance redemption of the current investors (simply because these new investors will face the same problem in a few years)
  • If the founders, in principle, agree to exit but there is no viable exit route, redemption rights will generally not change that.
     

Therefore, even though many deals include such rights, they are rarely invoked. Still, they send an important signal to the management and help set the focus of the management team on value maximisation. 

A typical term sheet formulation for redemption rights is:

 

Redemption: 

The Series A Preferred shall be redeemed at (I) a redemption price that shall equal the sum of (a) the Series A Purchase Price and (b) any declared but unpaid dividends on such shares of Series A Preferred (including the Accruing Dividends) and (II) there shall be no redemption of Series A Preferred upon an acquisition of the Company or upon a Qualified Public Offering (as hereinafter defined). If the Series A Preferred are not redeemed as required then the Investors shall have the right to designate a majority of the directors. 

 

When negotiating redemption rights, founders should focus on the following key issues:

  • If possible, entrepreneurs should try to knock them out entirely, as they can have potentially severe consequences, as described above.
  • If knocking them out is not possible, founders should try to defuse them:
    • Make sure that the rights cannot be exercised until at least five years after the investment
    • Limit the redemption price to the original purchase price. Try to avoid that any cumulative dividends are added to the redemption value.
  • Another important issue is what happens if the firm fails to redeem the preferred shares in cash. Sometimes, investors ask for enforcement provisions including the right to elect the majority of the board of directors. Since this corresponds to a factual loss of control, founders should push back on such provisions.
  • Finally, founders should reject any "MAC" redemption rights, that give the investors the right to redeem their shares in the case of a "Material Adverse Change" to its business.