If you’re in the process of raising capital, you’ve likely come across redemption rights in your term sheets. In this article, we explore what redemption rights are, how they work, and why investors in venture capital ask for them. We also cover how they can cause conflicts of interest and lead to disputes between startup founders and their investors.
What are redemption rights?
Redemption rights, also known as redemption provisions, are a type of contractual agreement between investors and the startups they have backed. These provisions are included in term sheets and enable investors to redeem their shares if certain circumstances occur, such as 1) a startup fails to meet performance targets or 2) a startup experiences an “adverse change” to its business.
How do redemption rights work?
Redemption rights are triggered by certain pre-defined conditions. These can include a startup’s failure to meet performance targets, a change in its business model, the loss of a strategic partnership or key customer, and other adverse changes. When these events occur, investors can invoke their redemption rights, which requires the company to repurchase their shares at the original strike price. Typically, startups have just 30 days to return the investor’s capital, or they’re subject to additional penalties. This timeframe is known as the redemption period.
What are the types of redemption rights?
There are several types of redemption rights that investors may choose to include in a term sheet. These include:
- Performance-based redemption rights: Performance-based redemption rights are triggered when a company fails to meet growth targets, revenue and profit milestones, and other financial metrics.
- Adverse change redemption rights: Adverse change redemption rights are triggered when a company experiences an “adverse change” in its business including changes to its management team or business model, and the loss of a key customer or strategic partnership.
- Redemption rights upon liquidation: Redemption rights upon liquidation are triggered when a company is acquired, goes public, or files for administrative dissolution.
Why do VCs sometimes require redemption rights?
Venture Capitalists often require redemption rights as a way to protect their investment in a startup. They give VCs an exit option should the company fail to meet certain performance targets, or experience adverse changes. In essence, this allows investors to recoup their investment if the startup’s future takes a turn for the worse. They are also sometimes used as a negotiation tool by VCs to “sweeten the deal”.
Why do startups agree to redemption rights?
Startups often agree to redemption rights because investors ask for them, and they naively believe that they won’t ever fail to perform or experience adverse changes. Startups may also agree to redemption rights because it provides reassurance that their investors are committed to their company and are “in it” for the long haul.
What are the implications of redemption rights?
Redemption rights can have significant implications for both investors and startups. For investors, redemption rights can provide them with an exit option should the company fail to perform. For startups, redemption rights can cause massive capital issues, should they fail to perform and their investors recall their investment. In this case, the startup would be forced to take the shares back and repay the investor. Redemption rights may also lead to conflicts of interest between investors and startups.
Why do redemption rights sometimes cause conflicts of interest?
Redemption rights can sometimes cause conflicts of interest between investors and startups in the event of poor performance. The investor may no longer believe in the startup founders anymore and wish to recall their investment, while the startup may need additional capital to “pull through”. If the investor envokes their right, they can force the company to repay them, causing even greater financial stress.
What are the advantages and disadvantages of redemption rights?
Redemption rights can be beneficial for both investors and companies, but they can also lead to conflicts of interest between the two parties. The advantages and disadvantages of redemption rights include:
- Redemption rights give investors an exit option should a company fail to meet certain performance targets or experience adverse changes.
- Redemption rights provide startups with the assurance that their investors are committed to the company and that they’re willing to invest in it for the long haul.
- Redemption rights enable startups to recoup shares from investors who no longer believe in the company, thereby reducing the overall dilution.
- Redemption rights can lead to conflicts of interest between investors and startups.
- Redemption rights can lead to startups being forced to liquidate their assets or raise additional capital, should they not have the money required to repay their investors.
Are investors who have redemption rights obligated to enact them?
No, investors who have redemption rights are not obligated to enact or exercise them.
When would investors waive their redemption rights?
Investors may choose to waive their redemption rights in a variety of circumstances. For example, an investor may choose to waive their redemption rights if the startup has historically performed well but recently had a poor quarter. Investors may also choose to waive their redemption rights if the company replaces members of it’s management team with more experienced individuals, or if the company ends a strategic partnership in pursuit of an even more strategic partnership.
In what situations should founders push back on redemption rights?
Generally speaking, redemption rights are rarely exercised. That said, there are a few circumstances when founders should consider pushing back against redemption rights to protect their interests in the event that they are exercised.
- Unlimited exercise window: occasionally investors will ask for open-ended redemption rights, which can be exercised at any time. Consider pushing back and only allowing investors to invoke their rights after three to five years.
- Redemption multiple: investors may request a multiple on their investment should their rights be invoked. Consider declining offers with multiples higher than 2x, or those that require cumulative dividends.
- Other stipulations: consider avoiding term sheets that would enable investors to take over your board of directors, should you not be able to repay them.
Closing thoughts on redemption rights
Redemption rights are sometimes required by venture capitalists, angel groups, or angel syndicates as a stipulation of their investment. Investors may leverage them in tandem with anti-dilution protection, pro rata rights, the most favored nations clause, and other contractual provisions to further protect their investment. While redemption rights can be beneficial for both investors and companies, they also may cause conflicts of interest and lead to disputes if the startup fails to perform or experiences adverse changes to its operations. Before agreeing to these rights, you must understand the potential implications so you don’t end up in a situation of needing to repay $10M, but only having $2M in the bank.