Whether you’ve only recently decided to seek out capital for your business or you’ve already received (or made) your first offer, the term sheet (or “letter of intent”) is an integral part of the process.
In this series we’ll look to shed some light on the legal language contained in that term sheet by taking a “deep dive” into the most often used terms and how choices made in selecting those terms can affect both Company and Investor. Check out an overview here.
In our earlier discussions on the rights and privileges set out in a financing term sheet (including our discussions regarding voting rights, dividends, and liquidation preferences), we’ve noted that the phrase “on an as converted basis” or “as converted” has been used in the model terms to describe the full capitalization of the Company.
But what is this “conversion”? How does it work? And how does it affect the rights and privileges of the Investors and their securities?
The answer is fundamental to the nature of preferred equity offerings.
In just about every preferred financing term sheet, there are two sets of conversion rights: “Optional Conversion” and “Mandatory Conversion”.
Put simply, “Optional Conversion” is the right of Preferred Stock to convert into Common at any time at the discretion of the holder. The NVCA model describes the right plainly:
The Series A Preferred initially converts 1:1 to Common Stock at any time at option of holder, subject to adjustments for stock dividends, splits, combinations and similar events and as described below under “Anti-dilution Provisions.”
We’ll discuss “Anti-dilution Provisions” next week (and they are quite important), but in respect of the primary right, the concept is simple.
At any time a holder of the Preferred Stock wishes, it may notify the Company of its desire to convert Preferred Stock (in the model term sheet, the “Series A”) into the Common Stock of the Company. This right initially starts on a 1:1 basis (i.e., every share of Series A converts into one share of Common Stock), but can “drift” into different ratios based on a recapitalization of the Company.
In other words, if the Company executes a stock “split” for which every share of common stock is now deemed to be 10,000 shares, it would not be fair, after the split, for each share of Series A to convert into only one share of common stock. And the same concept would apply (in reverse) in respect of stock combinations. The bit of language used in the term sheet to cover this concept stands as a marker for a few pages (or more) of legal language added to the Company’s certificate of incorporation. This language would, among other things, more definitively establish that when a recapitalization occurs, the conversion ratio would be automatically altered to put the Series A in the same position after the recapitalization as it would have been had it converted prior thereto.
All that said, given that we’ve spent weeks now talking about the many additional rights that the Preferred Stock is likely to have over the Common Stock of the Company, why would a holder convert? The answer is that, in most cases, they probably wouldn’t.
The “Optional Conversion” right is primarily one of flexibility and logistics. From the Investors’ side it is always more useful to have a greater number of options than fewer. After all, it is impossible to see the future, and you never know when the tax code or a given Investor’s financial situation might make it more useful (as unlikely as it may be) to hold Common Stock rather than Preferred.
On the Company’s side, the right is used primarily to help facilitate significant corporate events (mergers, acquisitions, etc.) if and when they happen. In other words, it is useful for the Company (and by proxy, Investors seeking to have the Company valued as highly as possible) to have a mechanism it can point to in which holders of the equity of the Company (all of which may have different rights and privileges) can consent to giving up those rights. Even in that context, however, the preferred stockholders often have no reasons to convert “in advance”.
Hence another conversion feature is needed.
The NVCA model term sheet describes the “Mandatory Conversion” obligation (things that are mandatory are generally not “rights”) as follows:
Each share of Series A Preferred will automatically be converted into Common Stock at the then applicable conversion rate in the event of the closing of a [firm commitment] underwritten public offering with a price of [___] 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 $[_______] (a “QPO”), or (ii) upon the written consent of the holders of [__]% of the Series A Preferred.
Simply put, this term states that (i) if the Company goes public in a manner which is likely to make the Investors a specific amount of money (on a per share basis) or (ii) if the Investors consent, as a group, then the Preferred Stock will be no more, and the Investors will hold only Common Stock in its place.
Now, both sides will generally agree to this term in concept. A Company going public will be deemed more valuable in the market if it has only one (or a small number of) common series of equity that can be easily understood by unaffiliated investors. Because of that fact, the Company really needs the ability to “wipe out” the Preferred’s rights and preferences if it wants to make a successful public offering. The devil, as always, is in the details. In this case, those details take the form of negotiations around the thresholds to be established for a public offering to be deemed “qualified” (the “Q” in “QPO”).
Because the application of this “Mandatory Conversion” term is a net negative for the Investors (as anything imposed upon a party would be), the Investors (and their counsel) will seek to have the thresholds set at a high level. The Company on the other hand, would prefer to have the ability to have a public offering on its own terms, without seeking the consent of the Investors. The lower it can have these thresholds set, the more flexible it can be for this purpose.
In other words, the fight may be around whether the Company has to beat a 5 times multiple on the Series A price or a 3 times multiple, whether it has to make $50 million rather than $35 million, and whether that money has to be “gross” or “net”.
While easy to look past given the hypothetical nature of the question (and because in all of these scenarios the Investors are going to make some real money), it is important for both sides to consider their positions here, and to really consider what a future public offering might look like.
Throughout this series, I will be basing my discussion in part on the order and prominence of certain terms set forth in the National Venture Capital Association (“NVCA”) Model Term Sheet. I’ve attached a copy to this post, but you can find additional copies (as well as versions of the definitive documents used to evidence these terms) here.
As always, if you’d like to discuss this post or your own company’s financing experiences please don’t hesitate to leave a comment down below or contact me at firstname.lastname@example.org.