Venture Capital Deals in IT: Redemption Rights

Today’s post in our series on the instruments of venture capital deals in IT under the English law is about redemption rights – rights to force the company to repurchase stock from stockholders.

What are redemption rights?

Redemption rights give a stockholder the right to demand a company to repurchase its stock in certain events. As a rule, when authorizing the issue and/or issuing shares of redeemable stock, the documents set forth not only the trigger for redemption, but also the terms and conditions of redemption: the price at which the company shall redeem the stock (or a formula for its calculation), the method for calculating the number of shares to be redeemed, and the period for exercise of redemption rights.

When does stock redemption occur?

In venture capital deals, redemption rights are granted to investors as a power to reclaim their investment in certain events. As a rule, redemption rights are punitive in nature and are used in case of defaults by a company or in other events having a negative effect on investors. These triggers may be:

• significant deviation from the agreed-upon business plan;
• inappropriate use of investment funds;
• failure to achieve the declared financial performance;
• change in the key team composition (founders and/or key employees).

An example of a trigger-violation: a startup raised $1 million to develop an AI text-to-speech software, but, instead, used the funds to develop another product without the investor’s approval. In this case, the investor (a holder of redemption rights) is entitled to demand the company to repurchase its stock on the predetermined terms.

Investors may also use redemption rights as an exit option (return of investment) if the company does not follow the planned business development scenario and, for example, the company does not go public or does not find an acquirer for a sale of the business.

What do you need to take into account in negotiating redemption rights?

The main terms to pay attention to are:

• triggers for the exercise of redemption rights;
• starting moment when the investor can exercise its rights: it is advisable for the company to defer it as much as possible – e.g., after 5 years from the deal closing;
• price at which the company shall repurchase the stock: usually, the price is set at the initial investment amount, i.e., the investor’s stock purchase price;
• deadline for the company to repurchase the stock upon receiving a request from the investor;
• consequences of the company’s failure to repurchase the stock by the deadline: in such a case, the investor may demand additional protective tools until the company completes redemption (e.g., the right to elect a majority of the board of directors, the obligation to obtain the investor’s approval for any expenditures). 

It should be noted that the concept of stock redemption works differently from jurisdiction to jurisdiction. For example, in some jurisdictions, companies can only redeem shares if those shares belong to a separate class of redeemable stock explicitly set forth in the company’s constituent documents. 

We recommend checking the company’s local legislation for the specific procedures of stock redemption.

Redemption rights are quite a strict term for the founders and, in practice, are much less common than other investors’ protective instruments. It is advisable for the founders to take this instrument out completely or, at least, make the exercise of such rights by investors as difficult as possible (i.e., avoid vague wording on redemption rights’ exercise triggers, deferring the starting time point for their exercise). Otherwise, in some cases (poor financial condition), the company may be forced to liquidate its assets or raise additional funding to pay off the investor.
 

The authors: Viktoryia Semianitskaya, Veranika Hrazheuskaya.