What is a Conversion Right?
Investors are issued Preferred stock and not common stock. Preferred stock typically has more economic value than common stock due to the rights and preferences that are granted with the issuance of such stock. One of these rights and preferences is conversion rights.
A conversion right is the right to convert shares of preferred stock into common stock. There are two types of conversion rights: optional and mandatory.
Optional Conversion Rights:
Optional conversion give the holder of preferred stock the right to elect to convert preferred shares common shares, typically on a one-to-one basis. These rights are related to the investor’s liquidation preference.
Here is an example, assume that a Series A investor has a $5 million, non-participating liquidation preference representing 25 percent of the outstanding shares of the company, and the company is sold for $100 million. The investor would thus be entitled to the first $5 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 $25 million.
Optional conversion rights are typically non-negotiable, standard, 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.”
Mandatory conversion rights:
Mandatory conversion rights require the holder to convert its shares of preferred stock into shares of common stock. This happens automatically and is sometimes referred to as “automatic conversion”. This is triggered when say when a company elects to go public (IPO).
Mandatory conversion rights are always negotiable and will look like this is 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 XAPreferred.”
There are several issues founders should focus on in connection with either type of conversion rights.
- The NVCA has a model term sheet that 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.
- 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 has to ensure 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).