SUMMARIZING KEY TERMS OF CONVERTIBLE PREFERRED STOCK
In venture capital (VC) financing transactions, convertible preferred stock is a typical investment instrument used to fund early-stage companies. Startups and other corporations that raise financing from venture capital firms will typically sell the investors preferred stock, not common stock. Common stock and preferred stock differ in a number of ways. A venture capital term sheet for any given deal will summarize the terms that will be included in that deal. Those terms commonly include most of those that are discussed below, although some of these terms are less common, or are less frequently used at different stages of a company's growth. Within each term category, there will be more or less opportunity to negotiate further specific terms, depending on the specifics of the deal, current market practice, current economic trends, and the relative leverage of the parties. As a securities law practitioner experienced in both angel financing and VC deals, I understand the importance to the client of comprehending the key provisions associated with convertible preferred stock. In this blog post, we will explore the essential elements that investors and entrepreneurs should be aware of before entering into such transactions.
I have been advising startups and investors in venture capital transactions and angel financing investments for over 20 years, guiding and counseling clients through the process, negotiating on their behalf, protecting their rights, and ensuring clarity and understanding of an otherwise stressful process. Read more about my Corporate Finance practice here.
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Dividend rights entitle preferred stockholders to receive dividends before common stockholders. This means that in the event the company declares dividends, preferred stockholders have priority over common stockholders in receiving their share of the profits. Dividends can be in the form of cash payments or additional shares of stock, known as dividend-in-kind. There are two main types of dividend rights associated with convertible preferred stock: cumulative and non-cumulative dividends. Cumulative dividends accrue and accumulate if unpaid, meaning that if the company skips dividend payments in one year, those unpaid dividends will carry over to subsequent years. Non-cumulative dividends, on the other hand, do not accumulate. If the company fails to declare dividends in a particular year, the preferred stockholders do not have the right to claim those missed dividends in the future. The specific terms regarding the payment of dividends are outlined in the company's governing documents. Note that it may not be worth the company's time and legal expense to negotiate too hard if the founders are concerned about dividends, as VC-backed ventures generally do not pay out dividends. (VC's are not looking for an interest rate for their return, but for the upside that comes from strong growth followed by an exit.) Dividend rights rights are set forth in the company's Certificate of Incorporation, and will or may be implicated by provisions of other documents used in the preferred stock financing deal.
The liquidation preference dictates the order in which shareholders are paid in the event of a company liquidation or sale. Preferred stockholders typically have a higher priority than common stockholders in receiving their investment back. The liquidation preference can be either participating or non-participating, influencing the amount investors can recover. Non-participating liquidation preference gives preferred stockholders the right to receive their liquidation preference amount before any distribution is made to common stockholders. Once the preferred stockholders have received their distribution, they do not participate further in the distribution of remaining assets, which are then distributed among the common stockholders. On the other hand, with a participating liquidation preference, preferred stockholders receive their initial liquidation preference amount before the common shareholders; but after that, they have the right to participate alongside common stockholders as though they were all a single class of stockholders, giving them two bites at the same apple. Liquidation preference rights are set forth in the company's Certificate of Incorporation, and will or may be implicated by provisions of other documents used in the preferred stock financing deal.
Convertible preferred stockholders often possess certain voting rights, granting them a say in the company's major decisions. These rights may include voting for the election of directors, approving mergers or acquisitions, or amending the company's charter. The specific voting rights associated with convertible preferred stock can vary based on negotiated terms and may be subject to certain protective provisions. Voting rights of the holders of preferred stock will be specified in the company's certificate of incorporation. But, note also that it is also common in a VC preferred stock deal for the investors and the company to enter into a separate Voting Rights Agreement, and for the investors to require other shareholders to sign the same agreement. The voting rights of holders of preferred stock are set forth in the company's Certificate of Incorporation, and will or may be implicated by provisions of other documents used in the preferred stock financing deal, and in particular will be affected by the Voting Agreement.
Protective provisions are safeguards that protect the rights of the investors in their capacity as preferred stockholders. These provisions typically require the company to obtain stockholder approval for certain actions that could adversely affect the preferred stockholders' rights. Protective provisions may cover matters such as changes to the capital structure, issuance of additional securities, or amendments to the company's governing documents, among others. Specific protective provisions can be the subject of negotiation during the term sheet phase. Protection provisions are set forth in detail in the company's Certificate of Incorporation, and will or may be implicated by provisions of other documents used in the preferred stock financing deal.
Conversion into Common Stock
One of the defining features of convertible preferred stock is the right or obligation to convert it into common stock. There are two possible types of conversion rights: optional, and mandatory or automatic. Optional conversion rights are typically not negotiated. Automatic conversion rights will provide that the preferred stock must convert into common under predetermined conditions specified in the company's governing documents. These conditions may include reaching a specific milestone, the passage of a certain amount of time, or the occurrence of a triggering event, such as an IPO. (In addition, if a "pay-to-play" provision is part of the deal, it may also result in a forced conversion.) Mandatory conversion rights are generally subject to negotiation, so startup founders and new investors should consult with legal counsel. Conversion price will be subject to certain conversion price adjustments. Conversion terms are set forth in the company's Certificate of Incorporation, and will or may be implicated by provisions of other documents used in the preferred stock financing deal.
Anti-dilution provisions protect preferred stockholders from dilution caused by subsequent financing rounds at a lower valuation. These provisions ensure that, if the company issues additional shares at a lower price, the convertible preferred stockholders' conversion price is adjusted downward, maintaining the value of their investment. There are a few different formulas for calculating anti-dilution rights: full ratchet, weighted average (broad-based, and weight average (narrow based); these differ in their respective "friendliness" to the founders and the investors, so care should be taken to consult with legal counsel before agreeing to one or the other in the term sheet. Anti-dilution provisions are set forth in the company's Certificate of Incorporation, and will or may be implicated by provisions of other documents used in the preferred stock financing deal.
Pay-to-play provisions incentivize investors to continue supporting the company in subsequent financing rounds. If an investor does not participate in a new financing round, these provisions may require the investor to convert their preferred stock into common stock or face penalties, such as a reduction in their liquidation preference or loss of certain rights. Pay-to-play provisions are set forth in detail in the company's Certificate of Incorporation, and will or may be implicated by provisions of other documents used in the preferred stock financing deal.
Redemption rights are not common overall in VC deals, and are quite rare in early-stage VC financing transactions. Redemption rights allow investors to require the company to repurchase their preferred shares after a specified period or under certain circumstances. These provisions can provide investors with an exit option if the company has not met predetermined milestones or if certain triggering events occur. Startup founders should push back if they are ever presented with a term sheet that contemplates redemption rights. Redemption rights, when included, are set forth in detail in the company's Certificate of Incorporation, and will or may be implicated by provisions of other documents used in the preferred stock financing deal.
Certain Rights of Investor-Appointed Directors
In some cases, investors holding convertible preferred stock may have the right to appoint one or more members to the company's board of directors. These investor-appointed directors may possess specific rights or veto power over certain decisions, ensuring their involvement in key strategic matters and protecting their investment. Companies should bear in mind that in early-stage financing rounds, investor-appointed directors are less common than investor's counsel sometimes like to insist, and, depending on other things, founders and management may not want to simply give in on this important control point without reviewing recent studies of what market practice actually is, and without a thorough understanding of the benefits that giving a board seat will provide in exchange for losing the degree of control that it represents. Rights of investor-appointed directors, are set forth in detail in the company's Certificate of Incorporation, and will or may be implicated by provisions of other documents used in the preferred stock financing deal.
Understanding the key provisions associated with convertible preferred stock in VC financing transactions is crucial for both entrepreneurs and investors before they agree to a venture capital term sheet that is presented to them. Each provision carries implications for the rights, priorities, and protection of the parties involved. The terms and concepts are generally complex and many are not intuitive. Many provisions will implicate or be implicated by provisions in multiple agreements used in the transaction. Engaging a knowledgeable legal advisor is essential to navigate the complexities of these provisions and ensure fair and beneficial terms for all parties involved.
Although term sheets are extremely important documents in the financing process, management teams should bear in mind that they the devil is in the details. The benefit of the term sheet is its function as a road map to the preparation of definitive deal documents. But, these documents are many and each is very detailed. Startup founders and other companies' management teams should educate themselves on the key terms of a venture capital financing deal involving convertible preferred stock. They should also understand the "habit" that some investors have to insist that every term they was should be given them because "it's market." But, no matter the sophistication level of the founders and management teams, these deals should not be done without the assistance of experience legal counsel; and, involving a CPA with relevant deal experience can also be extremely helpful. There are numerous legal, related tax, accounting, and business issues implicated in them. Contact an experienced corporate lawyer / securities attorney if you have been presented with a term sheet, or are contemplating negotiating a venture capital financing transaction. Make an appointment now for a free consultation.
This article is not legal advice, but is provided for general information purposes only: see the disclaimer in the footer of this site, and read my Legal Notices here.