Why does Conversion Rights matter?
Preferred stock carries rights common stock does not, such as a liquidation preference and protective provisions, and conversion is the mechanism by which those rights are given up in exchange for the different profile common stock offers. An investor generally only converts voluntarily when doing so nets them more money than keeping the liquidation preference would, exactly the calculation that plays out silently in the background of every acquisition once the actual sale price is known.
What does Conversion Rights look like in practice?
Suppose an investor holds preferred stock with a 1x non-participating liquidation preference on a $3,000,000 investment, convertible into 20% of the company's common stock. If the company sells for $10,000,000, converting to common nets the investor $2,000,000, less than the $3,000,000 preference, so they keep the preference instead. If the company sells for $30,000,000, 20% of that is $6,000,000, more than the preference, so the investor converts to common and takes the larger number.
What are the common mistakes with Conversion Rights?
- Assuming preferred shareholders automatically take their liquidation preference rather than modeling the exit scenarios where converting to common nets them more.
- Confusing mandatory conversion, automatic on an IPO regardless of any individual investor's preference, with the everyday optional conversion right investors hold at will.
- Not accounting for how the conversion ratio can be adjusted by anti-dilution provisions, changing when conversion becomes the better choice.
- Treating conversion rights as a minor mechanical detail rather than the hinge on which the liquidation-preference waterfall actually swings at exit.
Related concepts
- Liquidation PreferenceA term giving preferred shareholders (investors) the right to be paid a specified multiple of their investment back before common shareholders (founders and employees) receive anything from a sale or liquidation.
- Deemed Liquidation EventA contractual definition, in the certificate of incorporation, of which corporate events beyond an actual dissolution trigger payout of the liquidation preference, typically a merger, an acquisition, or a sale of substantially all the company's assets.
- Anti-Dilution ProtectionA term sheet provision that automatically adjusts an existing investor's conversion price, effectively giving them more shares, if the company later raises a round at a lower valuation than the one they invested at, protecting them from dilution caused specifically by a down round.