Editor’s note: Investor and entrepreneur David Gardner is the founder of Cofounders Capital in Cary and is a regular contributor to WRAL TechWire.

CARY – A good term sheet anticipates all of the typical outcomes of an investment and protects both the founders and investors from possible abuses.  In this article I’ll continue discussing how a good term sheet achieves this.

Next to valuation and founder vesting, redemption is arguable the next most misunderstood section of a typical terms sheet.  Redemption is an investor right that requires a company to repayment an investment after a certain number of years, usually five or six.  Entrepreneurs don’t like the idea that they may have to come up with a lot of money to buy out an investor if an exit has not been achieved by the maturity date and feel they may lose control of their company.

Professional investors expect to lose money on some of their early stage investments but that is not the only thing that keeps them awake at night.   Equally bad, and in some ways even worse, is a portfolio company that morphs into a lifestyle business.   A lifestyle business is one that is not really growing or moving towards any liquidity event but one that is cash flowing enough to provide a comfortable living for its founder.  Investors fear this state because their capital is tied up for a very long time with no way to ever get it back.

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To prevent this scenario, investors typically require, as a condition of their investment, a redemption date on which the company must return their capital.    Besides being a reasonable condition, redemption is not as draconian or as black and white as it sounds.   If a company has not morphed into a lifestyle business then either the company is doing well and growing i.e. still creating potential value for investors, or it is failing and out of money.

If the company is past the redemption date but still growing in value then investors will ignore their redemption rights.  Afterall, who wants to be bought out at cost when the investment is still increasing in value?   If the venture is failing and out of money, then the company is not able to buyout investors anyway and redemption is a moot discussion.

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What redemption really achieves is that it forces a discussion about when investors can expect a return or at least get some of their investment back.  I have had several investments extend beyond their redemption date but in every instance but one, redemption was ignored because I believed that the company was still growing and working towards an exit in good faith.   I did discuss redemption with one portfolio company that had flat revenues for several years and did not seem to be working actively towards an exit.  The last thing an investor wants to do is harm a portfolio company or to piss off the founders who can often kill the company just by walking away.   We agreed that the company would make payments over time and as profits allowed until my investment was returned.  This is slowly returning my investment while not harming the business or being too burdensome to the entrepreneurs.

I get worried when entrepreneurs push back too hard on redemption in my term sheets.  It brings about a good discussion to ensure that we are aligned with the founders thinking on exit goals.  Entrepreneurs often forget that fund managers also have investors to which they must answer.   We would be very poor fund managers indeed if we did not anticipate the occasional lifestyle portfolio company and how we would get our investor’s capital back in these scenarios.