Redemption Rights - 3 Things to Know about Redemption Rights in Term Sheets
In the world of startups, one of the most important factors to pay attention to on your term sheet has to do with redemption rights. The redemption rights definition is fairly straightforward - it's a clause that gives investors the chance to require a company to repurchase the shares that they were given after a specific period of time has passed. After this deadline, investors get the opportunity to put their shares back into the original company in exchange for a determined price.
In terms of redemption rights preferred stock, however, things can get a bit more complicated depending on the situation. As you move forward into the world of business, there are a few key things about the redemption rights venture capitalists (VC's) require that you'll want to know more about before investing in startups.
What Are Redemption Rights Designed To Do?
On the surface, redemption rights are a necessary part of doing business but aren't entirely something that you'll look forward to as you build your startup from the ground up. In practice, redemption rights are designed to protect one or more investors from a situation where your company isn't growing quite the way they expected. If you aren't moving forward and are instead just moving "sideways," according to Venture Beat, you're becoming a less attractive target for acquisition and that IPO may be much farther off down the horizon than you originally thought.
Because of this, redemption rights suddenly become a very clear progress indicator from your own perspective as the person in charge of the trajectory of the business. Are you suddenly very close to rebuying your investors shares of stock and more than a few of them seem to be willing to take you up on that? You may have bigger problems that you were unaware of until now.
The Majority Vote
Most experts agree that even though redemption rights are designed to protect investors, they still need to be created in such a way as to provide an additional level of protection to the business, as well. Many businesses that are successful enough to push forward but not quite powerful enough to go public (or attractive enough to be bought out) often run into issues where redemption rights can suddenly mean that the house of cards comes toppling down.
In this type of situation, it is always recommended that terms be drafted that require redemption rights to have a majority vote from all of your preferred shareholders before they can actually move forward. At the very least, this can help significantly delay a blow that could mean the end of everything that you've already worked so hard to build in the first place. It can also buy you a little bit more time to make some serious changes or progress if possible.
It Goes Beyond the Term Sheet
According to a survey of Venture Capitalists that was recently conducted by Fenwick & West, around 80% of all deals that were conducted in the San Francisco Bay area during the first quarter of 2015 included provisions about redemption rights at all. This is because even though they're designed to protect investors, they aren't necessarily working towards a solution that is entirely possible or even probable given the types of problems that can arise.
If you've run into an issue where investors are clamoring over redemption rights, you've entered something of a Catch-22. Your business isn't growing as quickly as they'd originally wanted and are looking to get out - however, if your business isn't moving the way you'd intended it to, you probably don't have the finances to buy back those original shares in the first place. In this type of situation, you'll want to brush up on all of the state-specific laws for the area where your business is based in - most states have restrictions regarding what has to happen if investors want you to buy back their shares but you don't have the funds necessary to actually do so.
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