Private equity and venture capital deals have a relatively common set of terms. Investors typically hold preferred stock that has specified approval rights. Anti-dilution, registration, preemptive, board representation, first refusal, and tag-along rights are common, although the details vary. And almost all the preferred stock purchased by investors has some form of redemption rights that generally give the investor the right to require the issuer to repay its investment at par, sometimes plus a yield, at or after a fixed period of time, usually not less than five years. Some of the rights granted to investors figure prominently in the ongoing relationship between owners and management. Yet, redemption rights generally receive little attention in deal negotiations, and even less attention over the course of the investment. They remain tucked away in the documents, largely forgotten, as the clock ticks toward the time when they may be exercised. However, redemption provisions have received increased attention in the current market environment. Many companies that raised preferred equity financing circa 1999-2000 have failed to achieve liquidity, as original expectations for exponential growth and rapid liquidity failed to materialize. These companies now have preferred stock in their capital structures that investors may elect to redeem. A number of these companies, however, do not have sufficient tangible assets to satisfy a redemption request. Investors in these companies typically are eager to monetize their long-held investments. Thus far, there has not been a rush to redeem. Yet discussions about the prospect and consequences of redemption occur with increasing frequency, prompting investors and issuers to take a closer look at the redemption provisions in their governing documents. As they do, they seek answers to questions such as: * What happens if redemption is requested and the company doesn’t have the money to fund it? * What rights arise if a redemption request is deferred? * Can a redemption request be revoked if an issuer’s prospects dramatically improve after the request is submitted? * How will the company’s accountants treat the preferred stock in the financial statements if the right to request redemption is exercisable or will be exercisable shortly? * What are the practical alternatives when there are insufficient funds to effect a redemption? In this article, we explore these issues and suggest answers. Types of Redemption Rights There are various types of preferred stock redemption rights. So-called “evergreen” provisions give the investor a preference or require the company to redeem the preferred stock only when the company is liquidated or sold. Mandatorily redeemable preferred stock requires the company to redeem the shares entirely on a specified date or on several dates after issuance, according to a schedule; redemption is not optional on the part of the holder or the issuer. Occasionally, redemption provisions take the form of a call, with the company having the right to redeem the stock after a specific number of years from the date of issuance, but these rights rarely are part of convertible preferred stock terms. There are also redemption rights that require the company to redeem the preferred stock, usually at the holder’s election, because of specified events, such as an IPO, a change of control, or the company’s failure to satisfy certain financial covenants. The most common form of redemption provides for redemption at the option of the investor after a specified date. Under these provisions, the holder of the preferred has the right, but not the obligation, to require the issuer to redeem the stock at any time after the fixed date, or sometimes within a prescribed period after this date. Some of these provisions contemplate redemption in a single payment while others contemplate a series of installments. In some cases the investor may make a separate redemption election with respect to each installment. Redemption provisions also may specify various penalties and remedies (described more fully below) that will apply if a redemption demand is not or cannot be honored. Inclusion of these remedies usually reflects the parties’ concern that such a failure may well occur. In this regard, redemption provisions differ from most other private equity and venture capital financing terms, which the parties generally expect will be met as agreed, making contractually specified remedies for non-performance unnecessary. Legal and Practical Considerations What happens when redemption is requested and the company cannot redeem the stock? When redemption provisions are short and simple, the remedies available to the parties who reach an impasse on payments will be those afforded under state law. The statutory and case law addressing redemption issues is not extensive in Delaware and quite limited in other jurisdictions. Section 160(a)(1) of the Delaware General Corporations Law (DGCL) principally governs the redemption issue, and provides that a corporation may not redeem its own shares of capital stock “when the capital of the corporation is impaired or when such purchase or redemption would cause any impairment to the capital of the corporation.” A corporation impairs its capital unless it redeems shares out of its “surplus” or the excess of net assets, i.e., total assets minus total liabilities, over the par value of the company’s issued stock. In light of Section 160(a)(1), a company with an obligation to redeem but with an insufficient surplus, even after a write-up of the balance sheet as contemplated by DGCL Section 154, has limited alternatives. To redeem stock under these circumstances or to pay penalty dividends when there is not an adequate surplus can result in personal liability for directors and possible liability for stockholders. Failure to honor the redemption request, on the other hand, would result in a breach of the agreement with the investors. A company that’s legally barred from effecting a redemption presumably will refuse to do so. If a compromise cannot be negotiated, the investor must resort to a state court by bringing a claim for breach of contract. An investor that wins a judgment also will become an unsecured creditor. The investor’s claim, derived from its ownership of an equity security, will be subject to the risk of subordination to the claims of other creditors if the issuer becomes a debtor in proceedings under the federal Bankruptcy Code. Thoughtworks Case In an ideal world, companies would honor their redemption obligations. They would anticipate coming redemption dates, build cash reserves sufficient to meet their payment obligations, and redeem their investors’ securities when requested and as the documents require. In fact, some profitable companies do just that. But most investors and companies do not live in an ideal world. A Delaware Chancery Court decision, Thoughtworks Inc. v. SV Investment Partners LLC, issued in June 2006, illustrates how redemption rights are viewed by the courts and the practical difficulties associated with enforcing them. The defendant in that case, SVIP (formerly Schroeder Ventures), made a $26.6 million investment in early 2000 in Thoughtworks, a Chicago-based IT professional services firm. At the time of the investment hopes for a near-term IPO were high. Nonetheless, the terms of the investment gave the preferred holders the right to require the company to “redeem the preferred stock, on the fifth anniversary of the closing, for cash-out of any funds legally available therefore and which have not been designated by the board of directors as necessary to fund the working capital requirements of the [issuer] for the [fiscal year in which the redemption would occur].” This was a hedge against a possible closing of the IPO window. Sure enough, shortly after the investment was made the demand for Internet service providers plummeted and the IPO window slammed shut. Beginning in 2003, two years before the scheduled redemption date, the company began to consider how it would honor the redemption and put its general counsel in charge of an initiative called “Solving the Put Program.” Acutely aware that it would not likely have $43 million (the aggregate size of the 2000 financing) to pay the preferred holders on the fifth anniversary, the issuer proposed delaying exercise of the put so that it could “maximize the return to the holders of the redeemable preferred stock without putting the company up for sale now.” The put was in fact postponed until June 2005 as the company tried to raise debt to fund the redemption. However, not enough debt capital was available and SVIP used its blocking right to prevent an expanded line of credit, also an issue in the case. The company offered to redeem the preferred stock for $12.8 million, or approximately 30 cents on the dollar. Some holders accepted the offer, but not SVIP. Unable to delay the put right by SVIP and “desperate to avoid entering into a transaction that could result in either substantial dilution of existing equity or a complete sale of the company,” Thoughtworks sued for a declaratory judgment that its charter allowed it to defer the redemption beyond 2005 and to reserve each year a sufficient amount to meet working capital needs, rather than use all legally available funds to redeem the preferred. The Chancery Court summarily rejected the company’s argument that the redemption language gave it a continuing right to defer redemption to the extent of working capital needs. It ruled that the company had to honor the redemption request to the extent of its legally available funds. The fact that this might well result in an early sale, either through a negotiated sale process or enforcement of a judgment by the preferred holders as creditors, was irrelevant. The preferred redemption terms were a contract to be honored. The court did not note, nor did the record indicate, where Thoughtworks might find the funds to honor its contract, or how a sale or merger would occur. Practical Approaches To Redemption Problems Litigation over a redemption provision would be highly disruptive for a company. From the investor perspective, enforcement of a claim as an unsecured creditor against a company with insufficient assets may not be an effective means of recovering capital. In light of the practical difficulties associated with enforcing a simply drafted redemption covenant, many investors build in contractual remedies to enhance and protect their redemption rights. Such a provision, for example, might give the issuer the ability to defer a redemption that would be illegal under state law, while requiring the company to take specified actions such as borrowing, refinancing, revaluing its assets or, more broadly, taking any necessary action to promptly remedy the situation. Sinking funds are rare, but some redemption provisions require a buildup of reserves as the redemption date approaches. Other common remedies include requirements to: * Pay dividends on the preferred stock after the redemption date at a higher and sometimes increasing rate until the redemption ultimately is executed; * Pay interest on the unpaid amount, with the rate increasing and interest compounding as long as there is no redemption; or * Issue warrants or other equity that dilute other owners’ interests. In each case the goal is to encourage the issuing company to complete the redemption. In many cases the holder of preferred stock that is not redeemed when requested remains a stockholder rather than becoming a creditor, or obtaining the rights of both. Some preferred stock terms expressly provide that the holder may elect to rescind the redemption request and submit it later, retaining its status as a stockholder and preserving equity conversion rights. One of the most common remedies for a failure to redeem, and one that often is strongly resisted by controlling founders and management, is a mechanism permitting the investors to gain control of the board of directors of the company until all required redemption amounts are paid. In theory, this gives the investor the ability to sell or refinance the company to satisfy the redemption demand. As a practical matter, a board takeover provision may be of little effect if management is critical to the company and refuses to cooperate in the sale. When it’s utilized, a board control provision should be coupled with appropriate voting agreements for transactions requiring stockholder approval. Board control provisions also require due consideration of the role of disinterested directors and relevant fiduciary considerations, particularly for transactions that may repay the dissatisfied investor but wash out all other stockholders. While the contractual protections and remedies described above can provide a degree of comfort for a preferred investor, it’s important to keep in mind that contract language alone does not guarantee that an investor will be able to force redemption. In view of the practical realities, some private equity and venture capital investors tend to view redemption provisions as a tool to prompt a negotiation with founders and management over the path to liquidity for a long-held investment. In reality, investors are reluctant to actually invoke redemption provisions since that can lead to a protracted and costly legal process, which may force a sale in a suboptimal manner or otherwise damage the issuer without assuring recovery of capital. At the same time, management and other owners know that a redemption provision can cripple a company, and they greatly fear that redemption provisions may be activated. In this environment of mutual fear and frustration, all stakeholders have an interest in finding a practical resolution so redemption provisions often serve as a means of prompting a revision of the deal leading toward a planned exit. Investors may agree, for example, to defer redemption in exchange for a higher dividend rate or a greater share of the equity. The company may agree to dedicate cash flow to fund redemption over time or to a specific course of action, such as retention of an investment banker, that leads to a liquidity transaction. Just the concern that a redemption request might be made is usually sufficient to change the status quo. Accounting and Tax Considerations Accounting and tax implications affect redemptions provisions. For example, FASB Statement 150 issued in 2003 provides that redeemable preferred stock will be treated as a liability on the issuer’s balance sheet and not as equity for financial accounting purposes if the stock is redeemable on a fixed or determinable date or at the time of an event that is certain to occur. The yield on the stock is treated as interest. For a time prior to adoption of FASB 150, there was concern that standard redeemable preferred stock, i.e., redeemable at the investor’s option after a given date, would be similarly treated. However, FASB 150, as finally adopted, excludes the standard type of shares from the definition of a mandatorily redeemable stock if the stock also is convertible, because redemption is not “certain to occur.” This preferred stock is sometimes included in a “mezzanine” category below liabilities but above equity. Some accounting firms increasingly question whether shares of redeemable preferred stock should be classified as liabilities, and it’s possible that future FASB guidance may increase pressure to again change the classification redeemable preferred stock. Any change in classification for existing preferred stock could be problematic to the extent that it adversely affects an issuer’s balance sheet or compliance with financial covenants. Balance sheet issues also arise as a redemption date approaches and an issuer is unable to honor a redemption request if it’s submitted within a year. In this circumstance, auditors may require a “going concern” qualification in their audit pursuant to the Statements of Auditing Standards (SAS 59, as amended). If liquidity is a foreseeable possibility, the company may negotiate with its investors to alleviate this problem, often through a formal amendment extending the redemption date specified in the charter. In some cases, a notice from the investors that they have “no present intention” of calling for a redemption within a year has resolved the problem. Investors seeking redemption will want it to receive favorable tax treatment as a “sale or exchange.” When the investor retains its equity interest, either in common or convertible preferred, following a redemption, the money paid to redeem shares may be treated as a dividend to the extent the issuer has earnings and profits. Of course, the consequences of such treatment have become less meaningful, with the federal tax on dividends down to 15%. Negotiation of redemption provisions at the time of a private equity or venture capital investment echoes in some respects the discussion of a prenuptial agreement before a first marriage. The prospect of failure seems remote. The date of redemption is far in the future. Raising concepts such as a takeover of the issuer’s board or a forced sale of the company are indelicate at best. Consequently, redemption provisions often receive far less attention than other financial terms. Because of practical difficulties, redemption demands are relatively infrequent. Yet, in a roundabout way, they help achieve the purpose for which they are designed – motivating the investee company to provide investor liquidity. Current experience demonstrates that redemption provisions, even if not performed as drafted, represent an effective mechanism for prompting negotiations that can lead to liquidity for long-held investments. By crafting redemption provisions with care and foresight, investors can better ensure that their 1x investments will in fact return no less than 1x, and have more time to devote to their 10x deals, while investee companies can better ensure that producing investor liquidity will not be a death sentence. John LeClaire is a Partner and Chair of the Private Equity Group at Goodwin Procter and Lizette Perez-Deisboeck is a Partner and a member of the firm’s Technology Companies and Private Equity groups. Both are based in the law firm’s Boston office. (c) 2006 Mergers and Acquisitions Journal and SourceMedia, Inc. All Rights Reserved. http://www.majournal.com http://www.sourcemedia.com

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