Financing Term Sheet Deep Dive: Redemption Rights

Whether you’ve only recently decided to seek out capital for your business or you’ve already received (or made) your first offer, the term sheet (or “letter of intent”) is an integral part of the process.  

In this series we’ll look to shed some light on the legal language contained in that term sheet by taking a “deep dive” into the most often used terms and how choices made in selecting those terms can affect both Company and Investor.  Check out an overview here.

Financing Term Sheet Deep Dive will be published each Monday morning until conclusion. For more information, check out www.hoeglaw.com or drop Rick a line at rhoeg@hoeglaw.com.

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Earlier in this series when we initially discussed the concept of dividends, we equated the idea to that of lenders receiving interest payments on the “loan” they made to the company.  In that context, “Redemption Rights” are the rights held by a company’s investors to call that “loan”; to force the company to buy them out.

While redemption rights are rarely, if ever used by the Investors that hold them, like so many rights that we have discussed in this series (and will discuss in the future), they are important because they set the playing field for future discussions.

In other words, they establish leverage; the nature of which you can see indicated in the header image to this post.

The NVCA model term sheet establishes the baseline concept of “redemption rights” quite plainly (formatting edited for clarity):

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)].

A few notes here.

Legal Prohibitions

First, the “prohibited by Delaware law” language is important (and not unique to Delaware companies).

Most state laws do not permit a distribution to stockholders (as the proposed “redemption” would be characterized) if the distribution would result in the Company’s becoming insolvent (i.e., if by making such a distribution the Company’s liabilities would exceed its remaining assets).  So if a Company isn’t doing well, it really can’t redeem its Investors’ shares by law, even if it has otherwise agreed to do so.

The problem is that “redemption” is not anyone’s desired outcome.  The Investors didn’t put money into a Company with the intention of forcing that Company to give it back. The only reason the Investors might be looking to have their shares “redeemed”, is because the Company isn’t doing well; the exact time that the Company probably can’t pay back the money in the first place.

So what are redemption rights used for?  Leverage, primarily.

If the Investors don’t like the way a Company is being directed or managed, redemption rights give them the ability to put a gun to the Company’s head (or a sword hanging over it) to move things in a way that they would prefer.  Such leverage can also be “pre-approved” at the term sheet level (though I rarely see this in practice), as the model term sheet itself notes:

[I]nvestors may seek enforcement provisions to give their redemption rights more teeth – e.g., the holders of a majority of the Series A Preferred shall be entitled to elect a majority of the Company’s Board of Directors, or shall have consent rights on Company cash expenditures, until such amounts are paid in full.

The takeaway here is that “redemption rights” are not usually used for what they “say”, but what they “represent”.  If the Investors have gotten to the point where they are seeking ways to get their money back, things are already very bad.  Redemption is a symptom of other issues, not the cause, and very often not the cure.

Not Immediately Available

The second item of note is the bit of language contained in the model term sheet regarding the rights “commencing any time after [________]”. This is also important.

As discussed above, the Investors’ exercise of their redemption rights is a “nuclear” option used primarily when things are going (very) wrong for the Company.  In most situations, the Investors’ removal of the entirety of their funds will spell the Company’s end (absent other life-saving measures), and so the Company is right to be wary of giving the Investors such power.  The timing component ensures for the Company that the Investors can’t simply “promise” $10M, have the Company make significant capital expenditures, and then have the Investors request it all back on Day 2.

Generally, the timer here is set for a number of years (usually between three and five), and before that time the Company owes no obligation to redeem its Investors.  The Company might have a sword hanging over its head, but the line cannot be cut for some time.

A Group Right

It is also important to note that the exercise of the redemption rights is done not by the Investors as individuals (at least not usually), but by a threshold percentage of the Investor class.  Generally, this threshold is set at the same level as the protective provision thresholds otherwise established in the term sheet (and the definitive financing documents).

Thus, both the Company and the Investors need to ensure that these approval thresholds are set appropriately at the term sheet level, even for as hypothetical a case as a redemption exercise, as neither side will benefit from being dragged into a redemption by an unexpected Investor group.

Structuring

Though the model term sheet doesn’t go into great detail here (“Redemption shall occur in three equal annual portions”), the parties may wish to establish, at the term sheet level, how a redemption would occur from a logistical perspective. Initial down payments, promissory note terms, secured interests in the stock sold, board seats or other control rights prior to payment; all should be on the table.

While some of these negotiations can wait until the drafting of the definitive documents, if a term is important to either the Investor or the Company (for whatever reason), it should appear in the term sheet.  That way both sides can know what they are getting into before they begin the long drafting and closing process.

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Throughout this series, I will be basing my discussion in part on the order and prominence of certain terms set forth in the National Venture Capital Association (“NVCA”) Model Term Sheet.  I’ve attached a copy to this post, but you can find additional copies (as well as versions of the definitive documents used to evidence these terms) here.

As always, if you’d like to discuss this post or your own company’s financing experiences please don’t hesitate to leave a comment down below or contact me at rhoeg@hoeglaw.com.

nvca-series-a-term-sheet

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