Redemption rights are rare in early-stage venture capital financings, but can sometimes be found in later stage financings, down rounds or in restructurings.
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Redemption Rights can be:
- Mandatory; or
Let’s explore these in more detail.
Mandatory redemption means that after a certain period of time (usually 5 to 7 years) the company must (assuming it can legally do so) repurchase stock from the preferred stockholders at a specified price. The specified price is usually the original purchase price plus any accrued and unpaid dividends. In some rare cases the redemption price might be a multiple of the original purchase price.
In mandatory redemptions, the company often can effect the redemption over a period of years (3-4 years is common), so that the company repurchases an equal portion of the stock over the stated period of time. The preferred stockholders may be given a right to “opt out” of the mandatory redemption, and instead remain as a preferred stockholder.
In some cases, the company can be required to set aside funds in a special account to prepare for the redemption. These are called “sinking fund” provisions, and the idea is to ensure that the company has sufficient funds to be able to effect the redemption.
Note that mandatory redemption rights are rare in venture capital financings. This is for a couple of reasons. Any cash the company has to pay out to preferred stockholders in the redemption means that cash isn’t available for the company to grow its business, and weakens the financial condition of the company (because of having less cash). Another reason is that if preferred stock looks too much like debt it will be recharacterized as debt on the company’s financial statements, which can have serious implications for the company (such as violating loan covenants requiring the company’s debt to equity ratio to be below a certain ratio).
Example. Assume the Series A preferred stockholders purchased 1 million shares of Series A preferred stock at $1.00 per share, for a total investment of $1 million. The Series A preferred stockholders obtained an 8% annual cumulative dividend, and a mandatory redemption provision that provided that after 7 years, the company must repurchase all of the Series A preferred stock at a price equal to the original Series A purchase price plus all accrued but unpaid dividends. The company pays no dividends. After 7 years, the company must repurchase all of the Series A preferred stock for $1.56 million, which is the original purchase price of $1 million plus the accrued but unpaid dividends of $560,000 (8% annual dividends * $1 million * 7 years).
Optional redemption exists where the preferred stockholders can vote to have the company redeem the stock after a period of time. The vote required is usually a “super-majority” such as 2/3 of the preferred stockholders must vote for the redemption for it to occur.
Optional redemption becomes available after some period of time (5-7 years is common) and the price is usually the original purchase price paid by the preferred stockholders plus any accrued but unpaid dividends. In very rare cases the purchase price may be a multiple of the original purchase price (such as 2x the original purchase price). The redemption is often made over a period of years (such as 3-4 years). Also, it is common to offer the preferred stockholders the ability to “opt-out” of the redemption if they want to remain as stockholders.
Redemption provisions aren’t common in early-stage venture capital transactions, but investors should be aware of how these provisions work in case the unique aspects of a transaction make redemption rights a useful provision to include in the financing.
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