What are the common conditions of preferred shares in Silicon Valley with regards to redemption rights?

A redemption right permits the investors to require the company to repurchase their shares after a specified period of time; it is, in effect, a “put” right – that is, the investors may elect to put their shares back to the company.  As a practical matter, however, redemption rights are rarely exercised and, according to Fenwick & West’s recent VC survey, only 20% of the deals in the San Francisco Bay area included such rights. 

Redemption rights are principally designed to protect investors from a situation where, after a period of time, their portfolio company is just moving “sideways” and, accordingly, is not an attractive acquisition target or IPO candidate. Investors are thus given the opportunity to exit their investment by
exercising their redemption rights – which is particularly important because
venture capital funds have limited lives (typically 10 years).

The problem, of course, is that a so-called “walking dead” company rarely has the cash to buy-back the investors’ shares.  Moreover, there are significant restrictions under applicable State law regarding redemptions if the company does not have the legally-available capital.  

There are several issues founders should focus on in connection with redemption rights. First, founders should push back to knock them out entirely because, as noted above, they are not the norm and rarely implemented. If the investors insist on redemption rights, the founders should only agree if such rights cannot be exercised until at least five years after the closing. 

Founders should also try to limit the redemption price to amount equal to the investment -- and push back hard on any cumulative dividends.

Investors will sometimes try to add enforcement provisions to give their redemption rights some teeth; for example, the investors may require that if the company defaults (cannot pay the redemption price in cash), then the investors will have the right to elect a majority of the Board of Directors until the redemption price is paid in full and/or the Company will be required to pay the redemption price via the issuance of promissory notes.   Again, the founders should push back hard.

Finally, founders should watch-out for unusual redemption rights, such as a “MAC” redemption pursuant to which investors are given the right to redeem their shares if the company “experiences a material adverse change to its business, operations, financial position or prospects.”  This is a non-starter.