By Alistair Barr
SAN FRANCISCO (Reuters) - Two of eHarmony Inc's main backers stand to gain extra leverage over the online-dating company in early November when redemption rights from its last financing round kick in -- an unusual development in the venture capital business.
The rights come into play after November 5 for Technology Crossover Ventures and Sequoia Capital, which invested when eHarmony raised $110 million in 2004.
The firms will have the right to require eHarmony to buy back their preferred shares in four quarterly installments, according to eHarmony's certificate of incorporation.
The company would have to pay $8.0158 for each preferred share being redeemed, matching the price of the original $110 million investment, or a "fair market value" agreed by eHarmony's board of directors and holders of most of the stock being bought back -- whichever is greater.
If the two sides can't agree, they have to appoint an independent appraiser to establish a value for the securities in 20 days, the certificate says.
"It's very rare that these redemption rights are actually exercised," said Curtis Mo, a Silicon Valley partner at law firm DLA Piper. "More often, if a company or management isn't performing, investors can use looming redemption rights as leverage to force some action like a sale of the company."
Redemption rights were included in fewer than one-fifth of venture capital financings in the second quarter of 2011, according to law firm Fenwick & West. What's more, it's unusual that they kick in.
Redemption rights are more common in late-stage financings, where venture capital firms like TCV offer some liquidity for company founders, according to Louis Lehot, a partner at law firm Sheppard Mullin.
"I can't recall a circumstance where they came into play -- in other words where the securities were redeemed," Lehot added. "They often cause some sort of non-public settlement ahead of time, like the company agrees to do an IPO or agrees to be sold."
However, a secondary market for stakes in private companies has emerged in recent years, giving founders and employees a new way of selling their stock. That's reduced pressure on management to work toward an IPO or sale.
"Company founders are no longer feeling the pressure to exit -- nowhere near as much as their venture capital backers," Lehot told Reuters. "There have been a number of liquidity transactions in the last couple of years. VC firms are very frustrated."
Mo and Lehot weren't talking specifically about eHarmony.
However, eHarmony shares have been posted for sale on a secondary market run by SharesPost at least three times since the middle of 2009. One completed secondary transaction in eHarmony shares from April 2009 is also listed on SharesPost.
EHarmony has been considered an IPO candidate for several years, although speculation about such an exit has died down a little recently, according to Anupam Palit, a senior equity analyst at GreenCrest Capital Management, which researches private, venture-backed companies.
"We view the company as a potential takeout candidate," Palit wrote in an April report that valued eHarmony at about $800 million.
EHarmony declined to comment, as did TCV and Sequoia.
EHarmony has less than $200 million on its balance sheet, so it probably wouldn't be able to meet redemptions without borrowing some money, Palit said in an interview with Reuters on Monday.
"I don't think that this means they would IPO because of this redemption issue," Palit added. "They would have to file very soon to go public in November."
Earlier this month, eHarmony hired Zynga executive Jeremy Verba as chief executive. Verba left Zynga soon after the social-gaming company filed for its own IPO.
"The new CEO needs to establish himself and build a reputation with investors before an IPO," Palit said. "However, he has some experience helping to prepare a company for a public offering."
(Editing by Steve Orlofsky)