What are redemption rights?
UK company law allows UK companies to issue 'redeemable shares'. These are shares which can or must be bought back (or 'redeemed') by the issuing company in certain circumstances. There are specific rules and procedures that must be followed in relation to both the creation of redeemable shares and their redemption.
The term 'redemption rights' refers to the circumstances which trigger redemption. For example, the share rights may require the shares to be redeemed:
- on a specific future date or in tranches over a number of dates;
- on the occurrence of a specific event e.g. the failure to pay an agreed dividend, or the passing of a resolution to wind up the issuing company or to change the rights attached to the redeemable shares; or
- at any time (or during a specific period) at the option of the investor or the issuing company.
What are the benefits of redeemable shares?
Redeemable shares can offer the parties a degree of flexibility and security.
From an investor's standpoint, holding redeemable shares can, depending on the redemption rights, serve as a safeguard against illiquidity as they give it an exit route when other routes (such as a sale or listing) may not be available. The investor also has the benefit of knowing that the price it will get is pre-determined (either by way of a pre-agreed fixed price or a formula). Typically, VC funds must return capital to their limited partners within fixed timelines. If a portfolio company stagnates or delays an exit, redemption rights provide leverage to encourage strategic decisions (such as pursuing a sale or recapitalisation) that can unlock value.
Having set dates for redemption offers a degree of certainty to the parties and allows for planning. The redemption period usually begins five to seven years after the initial investment, aligning with the typical VC fund lifecycle.
What are the drawbacks of redeemable shares?
From a founder’s perspective, redemption rights can introduce financial and operational pressure. If exercised, the company may need substantial cash reserves or access to financing to redeem the shares, which can strain resources and limit growth opportunities. In extreme cases, failure to honor redemption obligations can lead to investor enforcement actions, including forcing a sale or initiating legal proceedings.
Moreover, redemption rights can influence governance. Investors with redemption leverage may push for decisions that prioritise liquidity over long-term growth, potentially creating tension with founders who envision scaling the business over a longer term.
There are stringent rules relating to the creation and redemption of redeemable shares. Care must be taken to ensure these rules are followed as a mistake could lead to a redemption being deemed to be void and/or the company and its directors committing criminal offences.
Arguably the single biggest issue relates to financing the redemption. Typically, a company will need to have distributable profits at least equal to the redemption price to be able to proceed with the redemption. This can cause potential problems in particular for start ups. While there are other potential methods of financing a redemption (e.g. from the proceeds of a fresh issue of shares or out of capital), these are less commonly used as they are subject to certain restrictions.
There are also limited remedies available to an investor if the company fails to redeem shares when required to do so. The Companies Act 2006 specifically provides that if a company fails to redeem shares, it is not liable in damages in respect of that failure. It also provides that if the company cannot finance the redemption out of distributable profits, the court will not grant an order for specific performance to force the company to do so. It is possible to include specific provisions in the articles of association dealing with this scenario (e.g. providing that the company will redeem the shares as soon as it is able and restricting the ability of the company to pay dividends until the redemption takes place). The investor may also be able to seek an injunction preventing the company paying dividends until the redeemable shares have been redeemed. It is also not uncommon for other documents, such as an investment agreement, to include remedies in the event of a failure to redeem e.g. it may be an event of default which triggers other rights for the investor.
Negotiating redemption rights
Redemption rights are highly negotiable. Key considerations include:
- Timing - extending the redemption period gives the company more time to achieve a successful exit.
- Pricing - redemption price formulas vary, some include interest or dividends, while others cap returns to avoid punitive outcomes.
- Payment terms - staggered payments or instalment structures can ease the financial burden on the company.
- Triggers - redemption may be tied to specific events, such as failure to meet revenue milestones or lack of an IPO within a set timeframe.
Founders should seek to balance investor protections with operational flexibility, ensuring redemption rights do not become an existential threat to the business.
Conclusion
Redemption rights are a powerful tool in venture capital transactions, offering investors a contractual exit while introducing potential risks for founders. Understanding their mechanics and negotiating fair terms is essential for maintaining alignment between growth ambitions and investor expectations. Ultimately, redemption rights underscore the importance of clear communication and strategic planning in the VC landscape.
DWF has the largest venture and growth capital group in the UK with over 85 lawyers in 10 offices, and supports investors and companies across several sectors including financial services, technology, media and telecommunications, life sciences and healthcare and real estate and infrastructure.
If you have queries on any of the issues covered in this article please contact one of our experts.
