Venture Capital Deals in IT: Conversion Rights
- Why is it necessary to have the stock converted?
- What are the types of conversion rights?
- 3. What does “As Converted” mean?
We continue to uncover the instruments of venture capital deals in IT under the English law. Today's post in our series of articles is about the stock conversion rights.
Why is it necessary to have the stock converted?
Conversion rights refer to the rights of stockholders to convert their preferred stock into the common stock. In venture capital deals, conversion rights are considered as one of the investor's protective provisions. As a rule, when entering a company, the investor receives the shares of preferred stock and preferences attached thereto: in particular, liquidation preference, veto rights, preferred dividend distribution rights. Despite such a “preferred” status, at some point, it may be effective and profitable for the investor to convert its preferred stock into the common stock - at the point when the investor would receive more cash for the stock had it been the common stock rather than the preferred one.
What are the types of conversion rights?
There are two main types: optional conversion rights and mandatory conversion rights.
- Optional conversion rights are exercised at the stockholder’s discretion.
As a rule, the company’s documents include a provision entitling the preferred stockholders to convert their preferred stock into the common stock at any time, usually at a 1:1 conversion ratio. In general, optional conversion rights are exercised at the company's exit. The investor may have a 1x non-participating liquidation preference: the right to either receive its investments back in full, or to receive its pro-rata proceeds of the exit by converting the preferred stock into the common stock. At the exit, the investor chooses the most favorable option (giving more cash). If it is more profitable to receive its pro-rata portion of the exit proceeds, the investor will convert its preferred stock into the common stock.
- Mandatory conversion rights refer to the automatic conversion caused by predetermined triggers.
As a rule, automatic conversion occurs in conjunction with IPOs. For the IPO, it is a best practice and standard for the company to have a capitalization structure with all the stock being of the same class – common stock. The company’s documents may provide that, for the IPO to happen, all the preferred stock will be converted into the common stock, provided, however, that such an IPO meets certain criteria: e.g. the IPO stock offer price is at least X and the company's IPO net proceeds are at least Y. For the preferred stockholders, these thresholds are essential to ensure that they will get a reasonable profit from being forced to convert their preferred stock into the common stock. In contrast, for the founders, it is advisable to negotiate for relatively low thresholds in the IPO stock offer price and the IPO proceeds to be raised with a view to reduce the risk of the IPO being blocked by the preferred stockholders.
The automatic conversion may also be caused by a resolution of preferred stockholders (holders of at least a certain percent of the preferred stock). This conversion can mitigate the risk that minority preferred stockholders block key company decisions, including those that depend on a simplified capitalization structure (e.g., undertaking an IPO that does not meet relevant thresholds for the automatic conversion). The automatic conversion can also be bound by such triggers as the expiration of a certain period of time after the deal closing, the achievement by the company of revenue targets, etc.
3. What does “As Converted” mean?
The company’s documents and the deal documents often include a term “As Converted”: for instance, the dividend distribution section may state that dividends are calculated on an as-converted basis, the voting section may provide that the shares vote on an as-converted basis.
- “As Converted” means that, in determination of the preferred stock rights, it is supposed that shares of the preferred stock are converted into a certain number of shares of common stock (it is supposed only, there is no actual conversion). Initially, the conversion price is generally equal to the preferred stock purchase price, so, the conversion ratio is 1:1, e.g., 1,000 preferred shares are converted into 1,000 common shares.
However, the conversion ratio may change over time. For instance, if the conversion price decreases when the shares are diluted or new shares are issued at a lower price (i.e., down round), the conversion ratio increases, which means that the shares of preferred stock are converted into a larger number of shares of common stock. In our example, 1,000 shares of preferred stock may convert into 1,100 shares of common stock; in this case, the preferred stockholder would have 1,100 shares (not 1,000) for dividend distribution and voting. When drafting the deal documents, it is advisable to pay attention to the initial conversion ratio and the triggers for its change to avoid an excessively high conversion ratio resulting in voting and dividend dilution.
Conversion rights serve different purposes: structuring the investor's exit, flexible exercise of the preferred stock rights (voting and dividend rights), undertaking the IPO and simplifying the capitalization structure, mitigating the risk of decision blocking by the preferred stockholders. Each case, notwithstanding who is interested in the conversion, presents certain risks for the other party. Therefore, when negotiating the transaction terms and drafting the transaction documents, it is necessary to focus on triggers, conversion ratio and conversion requirements with a view to avoid adverse consequences (shareholding dilution, receiving low proceeds upon the forced conversion, IPO blocking, etc.).
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