Editor’s Note: Each week Maynard Webb, former CEO of LiveOps and the former COO of eBay, will offer candid, practical, and sometimes surprising advice to entrepreneurs and founders. To submit a question, write to Webb at firstname.lastname@example.org.
Q. A private equity firm invested in our company. It has a redemption right in which, if after five years things aren’t going as promised, the firm can force us to buy out its shares. The investor has made references to this of late as the right to exercise this option is upcoming. In the early years we didn’t live up to the lofty aspirations we raised money on, but lately the company has been doing very well. What are the chances that the investor is going to pull this card?
–Founder of a fast-growing retail company
It is not entirely unusual to see redemption rights in venture capital and private equity agreements. Typically, they allow for certain instances where the investor can sell their shares back at “par,” or at the original purchase price or face value.
While these provisions show up in some term sheets, they are rarely exercised in the real world. I think one reason for that is because investors want to have a good a relationship with other companies and this isn’t really the way to endear that. But it’s also because there are only a few instances in which it makes sense. If things are going well, an investor would never exercise this right because they would miss out on participating in the upside. And, if the company isn’t performing as expected, most likely an investor wouldn’t do this because the company wouldn’t have enough cash to pay.
The scenario where this comes into play is when a company is neither breaking out nor out of cash—what I call a ‘tweener. The company isn’t going up or down but staying sideways; it will never IPO or become a big acquisition target. Exercising a redemption right protects investors from getting stuck with what they see as a “walking dead” company. Private equity and VC funds have lifespans, often 10 years, so they can’t wait indefinitely for a liquidity event and may want to cash out this way.
It sounds as if you are not in this case; you are doing well but not as well as original projections. Therefore, this might be being used to force another change. An investor doesn’t have to exercise this right to use it as leverage to advance their agenda, which could include making changes to the board structure or management. It sounds as if they already are trying to flex this muscle.
You can’t blame investors for striking these kinds of deals and when in the exciting days of raising a great round, a founder may not think too much about these terms, but they are really kicking a can down the road if something doesn’t go well. It’s better to have clean term sheets without this downside provision. I’m not sure if you pushed back on this, but founders should. These rights can include onerous enforcement provisions such as requiring that if the company can’t pay in cash, then the investors will have the right to elect a majority of the Board of Directors until it is paid. There can also be something called a “MAC” redemption, which allows investors to redeem if the company “experiences a material adverse change to its business, operations, financial position, or prospects.” If possible, avoid agreeing to these terms.
Ultimately, it comes down to this: You accepted money from an investor and your job is to return it to them. Redemption rights exist—and are being mentioned to you now—as a reminder that the investment made will need to be returned. So, get to work making your company achieve its destiny. That’s the way to ensure that everyone wins.