Venture Capital Term Sheet: Redemption Rights

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1

What are Redemption Rights?

The term sheet may include a provision to require the Company to redeem ("buy back at the original purchase price plus an annual carrying cost") the preferred stock. Investors sometimes seek redemption rights as a way of obtaining a return on their investment if the Company does not go public or get acquired. Redemption provisions are fairly common in transactions, although mandatory redemption provisions are somewhat rare. Generally, in transactions that include redemption provisions, the majority will have a redemption provision at the option of the investor. Typically, redemption occurs over three or four years beginning five years after the financing, although some investors insist on total redemption all at once.

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How does the redemption right work?

A redemption feature allows the company to retire the preferred stock after a specified period of time (typically between 5 and 7 years) by paying the purchase price and, possibly, a small premium (although anything over 10% of the purchase price creates potential tax problems for the investors). A redemption call effectively requires the preferred shareholders to elect whether to receive their investment and little or no return, with a corresponding loss of the opportunity cost of having their money tied up for a number of years, or converting their shares into common stock, with a loss of their preferential rights. In the case where the investors see little hope of a successful exit for the company following a fairly long investment period, the redemption feature may be an attractive alternative for a venture fund.

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Mandatory Redemption Provisions

Mandatory redemption is more commonly requested by investors who are taking a minority position in the company. For these investors who may not have a strong position through the board or as a major stockholder, the notion is that the mandatory redemption feature will allow them to get their money out in the event the company becomes one of the "living dead" (i.e., no real prospects for going public or being acquired). Mandatory redemption is disadvantageous from the company's standpoint because of the potential for a significant outflow of cash. In this regard, if a mandatory redemption feature has to be included in order to get the deal done, a staged pay-out, perhaps spanning over a three-year period, is often negotiated.

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Negotiating Redemption Provisions

With the exception of mandatory redemption clauses, the redemption feature, like the dividend provisions, tends not to be controversial. As a practical matter, use of the redemption provision is quite rare, particularly for companies within California, since: (i) California corporate law prohibits payments to shareholders unless certain liquidity tests are met; and (ii) a company that can meet the liquidity tests is probably strong enough from a financial standpoint to go public or be acquired at a favorable valuation.

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Will the deal include redemption provisions?

Percentage of financings that include mandatory redemption or redemption at the option of the venture capitalist: Q3'07 26% Q2'07 22% Q1'07 26% Q4'06 22% Q3'06 29% Q2'06 33% Q1'06 27% Q4'05 31% Source: Venture Capital Survey, Silicon Valley Third Quarter 2007, Fenwick & West LLP

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Venture capital

Venture capital is a method of financing younger companies. Investors assume a high degree of risk, but tend to receive partial control over company decisions.

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