A redemption right is a feature of preferred stock that allows investors to require a company to repurchase their shares after a specified period of time. It is designed to protect investors from a situation where a company is not an attractive acquisition or IPO candidate.
As a practical matter, redemption rights are not used all that often. That is because so-called “walking dead” companies usually don’t have money to buy back the investors’ shares. Some recent surveys have found these rights are included in less than one-third of VC financings (and even less on the west coast).
There are also restrictions under state laws that can prevent a company from redeeming shares if it doesn’t have the legally available capital. In these cases, investors can request certain penalty provisions take effect. This can include a promissory note for the redemption amount and the investors being allowed to appoint a majority of the board of directors until the price is paid.
What does a redemption right look like?
The redemption may be triggered by a majority or super-majority vote of investors. The main considerations for startups in connection with these rights are the length of time before the right can be triggered and the redemption price. Often, the rights cannot be exercised for at least five years after the closing, which allows the company time to achieve results. The redemption price is typically equal to the original investment amount, plus accrued but unpaid dividends. Companies should push back against any cumulative dividends, which some investors might look to add.