Legal terms that have no practicable application
Sometimes I wonder why legal terms exist that have little or no practicable applicability – my clients wonder the same thing. Sometimes, these provisions really are ridiculous, but most of the time they cover off some eventuality that, although remote, actually could happen. The mere presence of the legal provision prevents the bad thing from happening, with the result that after some number of years, everyone starts to comment that whatever it is never happens and the lawyers have gone overboard. One example recently came to my attention: redemption provisions in venture investments. As everyone who plies these waters knows, a typical VC investment provides that, at the election of the investor, the company will redeem the investors stock after five years in three equal annual installments etc…. The purpose of these provisions, as I understand them, is to give the investor a way out of a landlocked investment in a life style company. In all my years of practice, I have never actually seen this provision at work. I think that is because long before anyone would actually pull the trigger on a redemption everyone sees it coming and something gets worked out. But, that begs the question of what would happen without the provision. So, here is a worthless provision (worthless in the sense that it never gets used) that actually serves its purpose – so well, in fact, that as a practical matter, the problem is extinct.
Comments (1)
Read through and enter the discussion by using the form at the endMike Feinstein - August 14, 2009 10:28 AM
Redemption may have been the wrong one to pick on. I've seen one deal where the VC was redeemed out. The company had a stable business and had built up a lot of profits over time. It wanted to be acquired, but had no takers as it was in a small niche (which it dominated). The redemption forced the company to either raise money from a new investor to pay out the original one (not very attractive), get acquired to make the whole problem go away, or pay cash out to the VC. The VC ended up negotiating some modified payout terms (higher payout over a slightly longer period of time) in order to be company-friendly. In the very long run, the company was sold. Had the VC stayed in, they may have made a bit more.
I don't think redemption is worthless. It's presence forces a company into action. VCs are investors -- they aren't your friend. They need a way out of a company where there is no other exit in sight. Normally, redemption gets reset on each succeeding round of financing, restarting the clock. But, venture investments have shelf-lives and born-on dates. When they start to get stale (no new investment round and no exit in sight), VC's get itchy. Note that a VC can voluntarily renegotiate the redemption if they believe that they can do better by waiting. But, they hold the cards on this one.
Think of redemption as a vaccine. The problem it solves isn't extinct. It still exists, and redemption rights are the anti-bodies that fight the problem.