Redemption and Misunderstanding
August 12, 2012
I recently ran into this situation around a very standard redemption provision.
About a year after the initial close, my client went to raise a medium sized extension round. They found a lead for the extension and everything went well. After some negotiation, we got to the last issue in the term sheet: redemption. The investor insisted that its redemption right be timed four years out to coincide with the redemption for the initial investment. The company, of course, insisted that redemption start at five years. They quickly reached impasse.
The CFO then asked me what to do. He sent along an email from the investor who explained carefully and reasonably that he did not want to be behind the initial investors.
I then sent an email to the group stating that our understanding was that all preferred would have the same redemption schedule – beginning five years after the extension closing not four years.
Needless to say, that closed the gap. The point is, I think, that there never was a gap.
It doesn’t make sense to have different redemption dates for different series. The result of such an arrangement is that one series is in danger of funding out another series. No investor should ever agree to such an arrangement. Also, as time passes and new investments are made the issuer is not going to want to be in a position to have to spend money to buy out investors rather than fund its business.
Redemption itself is not all that common a practice. It appears in only a small percentage of west coast deals and only about half (somewhat more than that actually) of New England deals. It is a rarely used provision. I can’t say never but ask a few practitioners how often they have seen it used. I bet the answer is almost never. I bet several will say they have never themselves seen it used in their practice. The fact that it is a rarely used provision makes it an easy give. This, I believe, is the reason why it is a minority provision on the west coast.
If you are going to have it, however, you probably want to make sure it really works. Investors in Thoughtworks, tired to use their redemption provision and discovered that the then usual and customary language about how redemption was subject to the board’s discretion around availability of capital. The NVCA form has addressed this issue and created a redemption provision that actually works.