The Denver Post | BUSINESS
Published: September 18, 2916 at 12:01 am | UPDATED: September, 15, 2016 6:26 pm
Last month I received numerous comments and inquiries regarding my column discussing the pros and cons of convertible debt. One problem that I did not address is the hidden trap of the liquidation preferences. Many entrepreneurs seeking capital from angel investors, venture capitalists or other early investors overlook this hidden trap as it relates to their convertible debt.
To understand liquidation preferences, and the hidden trap, it’s important to understand a few terms:
- Conversion cap: This is the maximum valuation of the company at which the note may be converted into shares by its owner, regardless of the actual valuation of the company. It is the “triggering” financing round that permits the note to convert.
- Conversion discount: This enables the convertible note holder to pay a lower price per share when converting the note into shares based on the triggering financing round. Investors in the financing round that triggers the conversion of the convertible notes usually purchase preferred stock in the company. Preferred stock typically permits the holder to convert the preferred stock to common stock at any time on certain terms, and certain contractual liquidation preferences.
- Liquidation preferences: These are the contractual terms determining who gets paid what — and in what order of priority — in contractually defined “liquidity events”. There are two types of liquidation preferences: Non-participating and participating.
- Non-participating liquidation preference: This gives the preferred stock holder a liquidation preference over the common stock holder equal to the per share price the investor paid or some multiple of that per share price. The holder can choose to convert his preferred shares to common shares or not. If the holder does not convert to common shares, the holder is paid the amount of his note plus any interest (paid in kind) before any of the common stock holders can share in the proceeds of the liquidity event. If the holder of the preferred stock chooses to convert to common stock, then he/she is paid the amount they loaned to the company first, plus any interest, followed by sharing on a pro rata basis of ownership any gain realized from the liquidity event.
- Participating liquidation preferences: These are the same as the non-participation liquidation preferences except, the holder of this preference, assuming the holder converts, is paid the amount loaned to the company first, plus interest, followed by his/her pro rata share of common stock ownership of the remaining profits before any other distributions are paid to the remaining common stock shareholders. Normally, the conversion ratio is one share of preferred stock to one share of common stock – a 1x conversion ratio. Although, depending on what has been negotiated between the parties, the conversion ratio could be higher.
Let’s assume that the founders of High-Tech Industries owned 3 million shares of common stock and Silicon Ventures invests $2 million to buy 2 million shares of preferred stock. The percentage ownership is 60 percent for the founders and 40 percent for Silicon Ventures (3 million common shares plus 2 million preferred shares = 5 million shares). Silicon Ventures has a non-participating liquidation preference at 1x of their investment amount or $2,000,000.
Suppose that High-Tech Industries was acquired for $10 million. The preferred stockholders convert their preferred stock to common stock to participate in the gain. If the preferred stockholders did not convert they would only be entitled to their liquidation preference, or $2 million. By converting to common stock with a 1x conversion ratio, the investors would receive their pro rata share of the $10 million along with all of the other common stock shareholders. Therefore, Silicon Tech Ventures will now hold 40 percent of the common stock and entitle them to 40 percent of the $10 million, or $4 million.
However, if Silicon Ventures had a participating liquidation preference, it would receive its $2 million original investment (the preference) plus the right to participate in the gain on a pro rata basis (40 percent ownership of common stock after conversion) in the remaining $8 million. Therefore, Silicon Ventures would receive their preference ($2 million) plus another $3.2 million (40 percent of $8 million) for a total of $5.2 million. The other common shareholder would receive 60 percent of the remaining $4.8 million ($8 million minus $3.2 million). This example is a 1x participating liquidation preference and is the most common liquidation preference for preferred stock owners investing in startups.
And now the trap. Imagine that Silicon Ventures owned preferred stock with a 4x participating liquidation preference.
Since High-Tech Industries sold for $10 million, the preferred stock owners would receive four times their original investment (4x the preference) or $8 million plus sharing 40 percent of the remaining $2 million or $800,000, for a total of $8.8 million. The founders and other early round shareholders would split 60 percent of the remaining $1.2 million. As you can see, Silicon Ventures received an outsized bounty.
What should you do about it?
Fortunately, this problem is easy to fix before finalizing the convertible debt documents. Fixing this problem later can be painful; you’ll either have to go back to early seed-round investors and ask them to give up some of their rights (never popular), or you’ll end up with a messy capitalization table. And for startups, your cap table mantra should be “cleanliness is next to godliness”.
Whether you’re a new entrepreneur or a seasoned one struggling to raise capital, it’s easy to let what seems like a minor detail slide. I see it all the time. So it pays to retain a knowledgeable attorney with expertise in creating convertible notes with liquidation preferences — before you start raising capital.
Gary Miller is founder and CEO, GEM Strategy Management, Inc. an M&A management consulting firm specializing in middle market privately-held companies. Gary’s team provides advisor services on M&A planning, exit planning, business transfers, preparing companies to raise capital, or owners to sell their companies, due diligence, valuations, and merger integrations. You can reach Gary at 970.390.4441 or firstname.lastname@example.org