Welcome back to our Anatomy of a Term Sheet series. We are taking the model Series A term sheet from the NVCA, and analyzing the various terms in depth.
The goal is to give startup founders a solid understanding of the complex provisions of the term sheet. We have had 9 installments so far, covering topics like the option pool, voting rights, the liquidation preference, dividends, conversion, anti-dilution, and pay-to-play. The next item in our series, and the last of the “charter items” that affect the Certificate of Incorporation of the startup, is the redemption rights term.
Here is the Redemption Rights term from our Model Term Sheet:
Unless prohibited by Delaware law governing distributions to stockholders, the Series A Preferred shall be redeemable at the option of holders of at least [__]% of the Series A Preferred commencing any time after [________] at a price equal to the Original Purchase Price [plus all accrued but unpaid dividends]. Redemption shall occur in three equal annual portions. Upon a redemption request from the holders of the required percentage of the Series A Preferred, all Series A Preferred shares shall be redeemed [(except for any Series A holders who affirmatively opt-out)].
The redemption right is basically the right of the Series A investor to have the company buy back its shares at a predetermined price. It is not very common for the investor to invoke this right, but the purpose is to protect the investor when the company is moving “sideways” – meaning the company isn’t looking like it is headed towards an acquisition or an IPO. As a practical matter, however, a company heading sideways may not have the kind of money needed to buy out the preferred stockholders. There may be restrictions under state law if the company doesn’t have legally-available capital, too.
Because redemption rights are rarely invoked, the founders should push hard to get them removed from the term sheet. As a fallback, the founders should negotiate to have the redemption rights not be exercisable within a certain time period after closing, for example, five years. Founders should also push to limit the redemption price to an amount equal to the original investment, rather than a multiple, and should try to exclude cumulative dividends.
That is it for the term sheet provisions that apply to the company charter. The next round of provisions apply to the stock purchase agreement, one of the documents that will be executed as part of the investment transaction.
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