Venture Capital Term Sheets: Conversion Rightsby Scott Edward Walker on June 9th, 2011
This post originally appeared as part of the “Ask the Attorney” column I am writing for VentureBeat; it is another installment of my ongoing series regarding venture capital term sheets. Here are the issues I have addressed to date:
- common mistakes dealing with VC’s
- liquidation preferences
- stock options
- exploding term sheets and no-shop provisions
- anti-dilution provisions
- Board control
- protective provisions
- drag-along provisions
- pay-to-play and pull-up provisions
In today’s post, I examine conversion rights of investors.
What Are Conversion Rights? As many of you know, VC investors are typically issued shares of preferred stock, not common stock. Indeed, preferred stock, as the name suggests, is preferable to (and more valuable than) common stock because it grants certain key rights to the holders, one of which is a conversion right.
A conversion right is the right to convert shares of preferred stock into shares of common stock. There are two types of conversion rights: optional and mandatory.
What Are Optional Conversion Rights? Optional conversion rights permit the holder to elect (not require) to convert its shares of preferred stock into shares of common stock, initially on a one-to-one basis. These rights are related to the investor’s liquidation preference.
For example, let’s assume that the Series A investor has a $5 million, non-participating liquidation preference (with a 2x multiple) representing 30% of the outstanding shares of the company, and the company is sold for $100 million. The investor would thus be entitled to the first $10 million pursuant to its liquidation preference, and the remaining $90 million would be distributed ratably to the common stockholders. If the investor, however, elects to convert its shares to common stock pursuant to its optional conversion rights (thereby giving-up the liquidation preference), it would receive $30 million.
Optional conversion rights are typically non-negotiable and will look like this in the term sheet:
“The Series A Preferred initially converts 1:1 to Common Stock at any time at the option of the holders, subject to adjustments for stock dividends, splits, combinations and similar events, as described below.”
What Are Mandatory Conversion Rights? Mandatory conversion rights require the holder to convert its shares of preferred stock into shares of common stock; it happens automatically (and thus are sometimes referred to as “automatic conversion”).
Mandatory conversion rights are always negotiable and will look like this in the term sheet (the blanks are thresholds that require negotiation, as discussed below):
“All of the Series A Preferred shall be automatically converted into Common Stock, at the then applicable conversion rate, upon (i) the closing of a [firm commitment] underwritten public offering of Common Stock at a price per share not less than ___ times the Original Purchase Price (subject to adjustments for stock dividends, splits, combinations and similar events) and [net/gross] proceeds to the Company of not less than $_______ ; or (ii) the written consent of the holders of ___% of the Series A Preferred.”
What Are the Key Issues for Founders? There are several issues founders should focus on in connection with mandatory (or automatic) conversion rights. First, founders should push for a low multiple of the Original Purchase Price (e.g., two or three times the Original Purchase Price) to create more flexibility with regard to an IPO.
Similarly, founders should push for “gross” (not “net”) proceeds and an amount in the range of $10-15 million; or, even better, “for a total offering of not less than [$10-15] million (before deduction of underwriters’ commissions and expenses).”
Sometimes experienced counsel can persuade the investors to eliminate these thresholds entirely (to avoid the possibility of having to obtain last-minute waivers when pricing the IPO); if not, the company must ensure that the thresholds are the same for all series of preferred stock.
Finally, founders should push for a majority threshold with respect to an automatic conversion upon written consent of the Series A Preferred; and if more than one series of preferred stock is issued, the holders should be required to vote as a class (otherwise a single series could block the transaction).
Are There Other Instances When Conversion Rights Arise? As I have previously discussed, conversions rights also arise in the context of pay-to-play provisions — i.e., there will be an automatic conversion from preferred stock to a “shadow” preferred or common stock if the investors do not participate in a financing; and they also may arise in the context of drag-along provisions, if the investors are required to convert to common in order to create majority approval of the particular “drag.”
I hope the foregoing is helpful. This is obviously a bit technical and generally requires input from experienced counsel. If you have any questions, please feel free to call me directly at 310-288-6667 (Los Angeles) or 415-979-9998 (San Francisco). Many thanks, Scott