- Venture capitalists are now attaching “redemption rights” to their investment offers.
- They give the investor the right to sell back their company shares at a specified date and price.
- “That can be crippling,” said Colin Kirby, a lawyer who represents startups in financings.
In a tepid market, tech investors are often able to set the terms of funding for startups. They might muscle in certain conditions that they probably would not get in a more founder-friendly market.
Colin Kirby has seen a lot of term sheets over his 11 years as a corporate lawyer. He advised advised founders and investors on hundreds of formation, funding, and exit transactions. And in recent months, as the funding market contracts, Kirby said he saw one clause creep into term sheets that preys on cash-strapped startups.
“This is my loathsome term: the forced redemption right, where in five, six years, the investor can come with their stock to the company and say, ‘Here’s my stock, pay me 1x what I invested or pay me 2x what I invested , “Kirby, a partner in Foley Hoag’s business practice, said during a talk at Startup Boston Week on Tuesday.
This is a choice that a growing number of founders are forced to make. They can agree to buy back an investor’s shares after a specified time or a certain occurrence, or squabble over the term sheet and potentially cause the investor to walk from the deal.
Signing off on these terms can put stress on startups to raise more funds or find a buyer before an investor’s redemption rights set in.
“That can be crippling,” Kirby said. “That means you’re looking for an acquisition two years or a year after you raised capital.”
Redemption rights aren’t new. In fact, they appeared in about one third of startup financings from 2005 to 2007, according to a survey of private-company financings by the law firm Wilson Sonsini. The provisions were designed to protect investors whose portfolio companies faltered in the dot-com era. But as the private markets boomed, power shifted from investors to founders, and venture firms stopped seeking redemption rights. In the first half of this year, only 8% of startup financings included the provision, down from 10% in 2021, Wilson Sonsini said in a report.
It seems redemption rights are now back on the table with the ongoing uncertainty in the private markets. Kirby said founders can expect harsher deal terms and more aggressive due diligence while investors hold more leverage. In rare cases, he’s seen investors ask to be paid dividends on their investment at the time of a sale or IPO.
“The investors say there’s inflation and we don’t know what’s going to happen. And I tell the founders why is that my fucking problem,” Kirby said. “That can be really onerous.”
As for redemption rights, Kirby tells investors it’s not in their best interest to get that term. The provision can spook other investors and hurt the company’s trajectory.
He said, “Any other investor is going to be nervous about putting money into a company where there’s a call right in three years on capital coming out that, if called, would put the company underwater.”