Term Sheets: What are redemption rights?

This week we continue our series on key VC financing deal terms.

This week’s question: What do I need to know about redemption rights?

Our answer: Redemption rights are provisions sometimes used in venture financings to give investors the ability to force a startup to repurchase their shares after a certain period (usually 5 to 7 years) if there is no exit event (eg. acquisition or IPO) and a specified threshold of preferred shareholders requests it. The redemption price is usually the original purchase price, but may include accrued dividends or interest. These rights are common in later-stage financings or investor-friendly situations such as down rounds, slow growth, or uncertain market conditions. Redemption rights require act-specific analysis more than most financing terms, but we generally recommend reserving them for later-stage startups with a mature business model, realistic plans for exit, and a strong need for additional capital.

Key Considerations

While redemption rights offer downside protection for investors by giving them a path to recover if the startup stalls, these rights may create significant pressure on your startup if not properly structured. In particular, if investors also have board or other control rights, redemption rights can be used as leverage to force strategic decisions or premature exits.

Below are the key terms and considerations reflect what we consider general best practice to avoid such a situation:

1. Redemption Period. Seek the longest redemption period possible (ideally 7+ years from the investment date) to give your startup time to grow and pursue an exit. A period under 5 years should be avoided.

2. Redemption Triggers. Should require approval by a majority (or greater threshold) of preferred stockholders, not on an individual basis, and avoid broad or subjective triggers such as hitting revenue milestones or CEO departure because these are too unpredictable and risky.

3. Payment Structure. Payments should be made in installments (eg. 3 equal annual payments), not a lump sum, to avoid straining cash flow. Payment should be from “legally available funds” (ie. surplus cash or retained earnings), not cash that jeopardizes solvency or forces taking on of debt or liquidating assets to meet redemption obligations.

4. Penalties. Non-payment penalties such as interest and greater voting rights should be resisted or softened to avoid giving investors more leverage when cash is tight.

Why It Matters

While redemption rights may be a reasonable tool for later-stage investors seeking protection from exit uncertainty, they create major financial obligations. Thoughtful negotiation and careful structuring are essential to preserve your startup’s ability to grow without the burden of future financial strain from forced repurchases that could derail long-term plans.