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Venture Capital Term Sheet Negotiation — Part 5: “As Converted” and Conversion Rights of Preferred Stock

This post is the fifth in a series giving practical advice to startups with respect to understanding and negotiating a venture capital term sheet. 

In the prior four posts, we provided an introduction to negotiation of the term sheet and discussed binding and non-binding provisions, discussed valuation, cap tables, and the price per share, discussed dividends on preferred stock, and explained how liquidation preferences work. This post will explain what “as converted” means and discuss conversion rights and features of preferred stock.

“As Converted”

When reviewing the National Venture Capital Association’s (NVCA) Model Legal Documents, you’ll notice use of the phrase “on an as-converted basis” in several areas.  For example, the NVCA term sheet section on dividends provides under Alternative 1 that dividends will be paid on the preferred “on an as converted basis when, as, and if paid on the common.”  Similarly, under the discussion of voting rights, the NVCA term sheet provides that the preferred votes together with the common “on an as-converted basis.”

This “as converted basis” concept means that, when determining the right or benefit of the preferred stock, it is assumed that the preferred shares have been converted into some number of common shares. To determine the number of common shares into which the preferred shares are deemed to convert, you simply multiply the number of shares of preferred stock in question by the conversion ratio.  The conversion ratio is the price paid for the shares of preferred stock (e.g. the Series A Original Issue Price) divided by the then current conversion price.  Initially, the conversion price is usually set to equal the issue date price so that the initial conversion ratio is 1:1.

As an example, assume 25,000 shares of Series A Preferred stock is initially purchased for $10.00 per share (the “Series A Original Issue Price”) and has a $10.00 per share Series A Conversion Price so that the initial conversion ratio is 1:1.  If there have been no adjustments to the Series A Conversion Price after the issuance of the Series A, then 25,000 shares of Series A Preferred will be deemed to convert into 25,000 shares of common stock for purposes of determining the rights or benefits of the preferred stock (e.g. voting rights).

However, if there have been diluting events, the conversion price may have been adjusted downward (we’ll discuss anti-dilution calculations more specifically in a future post).  If we assume a conversion price of $8 per share due to dilution adjustments, the new conversion ratio would be 1.25, which equals $10 (the Series A Original Issue Price) / $8 (the current Series A Conversion Price).  This means our 25,000 shares would be deemed to convert into 31,250 shares of common for purposes of determining the right or benefit of the preferred stock (again, if we are determining voting rights, for example, this will mean the 25,000 shares of preferred stock receive 31,250 votes).

Optional and Mandatory Conversion

The “as converted” concept is fictional in the sense that the preferred shares have not actually been converted.  Instead, we are assuming conversion simply to calculate the quantity of votes or dividends or some other right of the preferred stock.

However, the preferred stock may convert into common stock upon certain events.  As noted in the NVCA term sheet, there is a section called “Optional Conversion” which simply states that preferred stock may be converted into common stock at any time at the option of the stockholder and notes the initial 1:1 conversion ratio.

Why would a stockholder convert his or her shares from preferred to common?  Depending on the structure and economics of the deal, the stockholder may receive more cash upon liquidation if the shares are converted into common shares.  For example, a common structure on liquidation might be for the preferred stockholder to either (i) receive a liquidation preference equal to return of its initial investment (or some multiple thereof) or (ii) to convert to common and give up the liquidation preference (i.e. this is a non-participating preferred structure, which we’ve discussed previously).  If the sale price is high enough, the stockholder will receive more by giving up its liquidation preference and participating as a common stockholder.  To reuse our example from our post on liquidation preferences, let’s say that a venture capital fund takes a 20% interest in Company X for $2.0 million.  The price is $1 per share with a non-participating 1x liquidation presence and no preferred dividends.  Assuming there are 8 million common shares outstanding, the VC fund would receive 2 million preferred shares.  If Company X is sold a few years later for net proceeds of $30 million, the VC would receive $2.0 million if it chooses not to convert, but would receive $6.0 million if it converted its shares to common stock.

The NVCA term sheet also provides for mandatory conversion upon an initial public offering, provided certain minimum thresholds are achieved, or upon written consent of the Series A stock.  In this model term sheet, the minimum thresholds for conversion upon an IPO are that the IPO stock be sold for some minimum multiple of the initial preferred purchase price and that the company receives some minimum amount of proceeds.  These thresholds provide some assurance to the holders of preferred stock that it receives a reasonable return before being forced to convert its shares to common stock.

In negotiating the term sheet, founders should press for a relatively low multiple of the original purchase price (perhaps 2x to 3x) and total proceeds required to be received to minimize disruption of an IPO by the preferred stockholders.

In the next post we’ll discuss voting rights and protective provisions.

This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

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Casey W. Riggs

Casey Riggs is a corporate and business attorney who represents companies of all sizes, from startups to large corporations, and in all stages of the business life cycle, from entity formation through an exit event. Casey also represents many of his clients in estate planning and administration.

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