What are redemption rights?
Takeaway: Redemption rights are a rare and aggressive term that gives an investor the right to demand their money back after a certain period of time; founders should strongly resist this provision as it can create a major future liability for the company.
As you review your Series A term sheet, you will encounter a long list of rights associated with the Preferred Stock. Most of these, like a liquidation preference and anti-dilution rights, are standard and expected. However, there is one right that is a major red flag and is not considered "market standard" for a typical venture capital deal: redemption rights.
A redemption right is a provision that gives the investor the right to force the company to redeem (i.e., buy back) their shares at a future date for a specific price. This effectively turns an equity investment into a form of debt, creating a ticking clock that can put the company in a precarious financial position.
How Do Redemption Rights Work?
The provision will typically state that at any time after a certain date—often five to seven years after the financing—the holders of a majority of the Preferred Stock can vote to demand that the company redeem all of their shares.
The Redemption Price: The price is usually set at the original purchase price paid by the investor, sometimes plus a small, pre-agreed upon annual dividend.
The Problem: Five years after your Series A, your company may still be private and may not have a large amount of free cash on its balance sheet. A demand from your investors to be bought out could create a major liquidity crisis, forcing the company to seek a premature sale or a disadvantageous financing simply to generate the cash to redeem the shares.
Why Would an Investor Ask for This?
Redemption rights are a feature of the private equity world, where funds have a fixed life and need a way to force a liquidity event. While some venture funds have adopted this term, it is generally seen as being out of step with the long-term, patient capital model of venture capital. An investor might ask for it for several reasons:
To Force an Exit: It gives them a powerful tool to force the founders to seek a sale of the company if it has become a "zombie"—a stable, but slow-growing company that is not on a path to a major venture-scale exit.
An Aggressive Negotiating Tactic: Some funds include it in their standard term sheet simply as an aggressive opening negotiating position.
Why You Should Resist Redemption Rights
For a founder, redemption rights create a significant future liability and a loss of strategic control.
It Creates a Debt-Like Obligation: It fundamentally changes the nature of the investment from risk equity to a debt-like instrument with a future maturity date.
It Can Force a Premature Sale: It can give your investors the power to force you to sell the company at a time that may not be in the best interest of the common stockholders.
In a competitive fundraising environment, most founders should be able to successfully argue for the removal of a redemption rights clause from their term sheet. It is a non-standard, aggressive term that is not aligned with a long-term partnership between founders and their venture investors.
Disclaimer: This post is for general informational purposes only and does not constitute legal, tax, or financial advice. Reading or relying on this content does not create an attorney–client relationship. Every startup’s situation is unique, and you should consult qualified legal or tax professionals before making decisions that may affect your business.