VC Vocab: What are Redemption Rights?

Redemption rights are the right of an equity holder to sell their shares of a company back to the company at hand. Redemptions rights are a term found frequently in venture capital term sheets. Now, before you start scratching your head about this, please keep in mind that there are a handful of practical - not technical - aspects of redemption rights that need to be elucidated.

It’s important for me to clarify that I have never seen redemption rights exercised in a real setting. That’s not to say that they aren’t enforceable or that no one ever utilizes them, but just that the scenarios in which redemption rights are enacted are pretty uncommon. So while you should understand them as an entrepreneur or as an investor, hopefully you shouldn’t have to spend too much time thinking about them. They are what some might refer to as a “downside provision”. While I disagree with the idea behind that quoted term, I do think that is important to remember: redemption rights would only ever be enacted during a downside scenario for a company, and a pretty rare downside scenario at that.

There’s not much more to the technical function of redemption rights other than how it was described above - the right of an investor to sell their shares back to the Company. Redemption rights typically allow for the investor to sell their shares back at “par”, meaning at the original purchase price or face value. In other words, a VC gets all of their initial capital back if they exercise their redemption rights. During an upside scenario, a VC would never do this because they would miss out on the chief economic incentive that drives their fund - making a positive return. And during a wind-down scenario, a VC wouldn’t do this either, because, during a wind-down, a company rarely has enough cash to pay back investors in this manner.

So the only scenario where redemption rights come into play would be when a company goes “sideways” - meaning they aren’t growing like a high-growth startup, but they also aren’t about to run out of cash. Instead the company is plodding along safely. There is absolutely nothing wrong with a low-growth business (they are a vertebrae in the backbone of this country), but venture capitalists sometimes have a hard time making a return on a business like that. They don’t normally become exit opportunities in enough time for the VC fund’s life-cycle. So instead, a VC might just exercise their redemption rights and have the company buy-back their stock. But even this is a somewhat unlikely because there are probably easier, better markets for the stock than selling it back to the company. There are other private capital allocators with longer investment horizons who would like to invest in the Company for one reason or another. The company’s management team could also purchase the stock back, which would be a much simpler transaction. Management would probably prefer to do this if they have the capital resources available - they get to own more of the company and have fewer investors to answer to.

It’s also important to remember that most redemption rights have a timeline trigger - meaning they are not exercisable until a certain anniversary after an investment is made - typically five years. This timeline is put in place because VC’s are normally working with a constrained timetable to see investment returns. Most venture funds have a lifespan - normally ten years - and need to return their capital in that window. There are also various other features of redemption rights, such as how many investors are needed to approve the exercise of the redemption rights and how the redemption occurs logistically - does it happen in one payment or a variety of installments over several months or years. But compared to other venture terms, redemption rights are typically pretty down the middle and don’t have a ton of variety. They mostly exist as a reminder to founders and investors that the investment made eventually needs to be returned.

The venture capital term sheet can be a particularly complex, confusing non-binding contract. There are a lot of terms that get littered in there that can be confounding to an untrained eye. I work in venture capital and with term sheets every day, and I still find myself scratching my head trying to wrap my brain around a concept here or there. I am not ashamed of that, but it does go to show that a financial transaction (any financial transaction) can be difficult to navigate. So while you consider redemption rights, I strongly recommend you find good counsel and you trust what they say. There are times to bootstrap your way into success and there are times to spend good money - your legal counsel is the latter.

Peter G Schmidt