Court Of Chancery Upholds Limits On Redemption Right
SV Investment Partners, LLC v. Thoughtworks, Inc., C.A. 2724-VCL (November 10, 2010)
Private equity investors often want to use preferred stock to invest in a company. In doing so the investors expect to be cashed out at some defined point. They frequently provide for that by having the certificate of incorporation require mandatory redemption of the preferred stock. One customary limit on those redemption rights is that only "funds legally available" be used for the redemption. Investors may assume that means that if the company's assets exceed its liabilities that redemption is required at least to the extent of the excess.
Well if they think that they are wrong. This decision holds that the "funds" available refers to the company's cash and that cash may only be used if to do so will not impair the company's ability to pay its creditors in due course. As a result, what seemed like mandatory redemption may instead be put off indefinitely.
This is not just a simple matter to cure by drafting, however. While it is true, as the decision points out, that all sorts of investment vehicles exist to permit an investor to demand and get back its investment, those may not always be appropriate. Preferred stock has the advantage of being treated as equity on a balance sheet. Other investment vehicles may not have that advantage.
The real issue is who calls the shots once the mandatory redemption deadline passes without redemption. If the investors want to do so, then they need to bargain for that power when they make their investment.
This decision was affirmed by the Supreme Court on November 15, 2011.