NOTE: This is the sixth post in our series about standard terms in early stage equity financings. These posts refer to the model Series A Term Sheet put out by the National Venture Capital Association (NVCA) and available for download here.
* * * * * * * * * *
In this post we look at when an investor’s preferred stock may or must convert to common stock, and how the conversion ratio may be adjusted in certain circumstances.
Optional Conversion and Mandatory Conversion
Preferred stock typically converts to common stock either:
(a) at the option of the stockholder (“Optional Conversion”); or
(b) automatically (i) at the time of the company’s initial public offering (usually subject to the public offering share price being at least X times the per share price paid by the investors) or (ii) if at least X% of the investors agree to convert all preferred stock held by all investors (both (i) and (ii) being “Mandatory Conversion”).
The conversion provisions are important to the investors – who do not want to be forced to convert before it is most advantageous to them – but of little consequence to the company and generally are not the subject of much negotiation, but there are two points worth mentioning. First, for a Mandatory Conversion upon an IPO the threshold public offering price, if there is one, is sometimes a topic of disagreement (typically 3X-5X the original purchase with a higher threshold giving the investors more control over the timing and terms of an IPO), but it is important to keep in mind that investor approval will always be required for an IPO regardless of the threshold (either explicitly or because of the amendments to the corporate charter that will be required before the company goes public). Second, the other issue of some concern to the company is what percentage of investors can compel all investors to convert to common. The company prefers that the percentage required is not so high as to make obtaining approval burdensome. Typically, the percentage required to force conversion is the same as that required to approve matters subject to the investors’ Protective Provisions.
Anti-dilution Provisions
While the timing of conversion is not a very hot topic in negotiating a term sheet, the anti-dilution provision can be if the investors decide to play hardball. The ratio at which preferred stock converts to common stock is initially set at 1:1, but the ratio is typically subject to adjustment in a variety of circumstances. Certain adjustments merely compensate the investor for changes in the company’s capital structure – for instance those caused by a stock split, reverse stock split or stock dividend – without altering the economics of the preferred stock. Other adjustments, however, are intended to protect the investor against dilution caused when the company issues shares at an effective price-per-share lower than the price-per-share paid by the investors (a future financing at a lower price is called a “down-round”). These adjustments are referred to as “price-based” anti-dilution protection.
Price-based anti-dilution protection operates by increasing the number of shares of common stock into which a share of preferred stock converts (i.e. it increases the conversion ratio) and has the effect of causing the company’s common stockholders (who do not have anti-dilution protection) to be diluted twice: once by the issuance of the shares to the new stockholders and a second time as a result of the adjustment to the conversion price of the preferred stock. The anti-dilution protection provisions can, therefore, have a significant economic impact. There are two types of price-based anti-dilution protection typically found in angel and VC financings: full ratchet (very investor favorable) and weighted average (less investor favorable). Note that the third alternative – no price-based anti-dilution protection (company favorable) – is often seen in pre-VC financings, but almost never in VC deals.
Full ratchet anti-dilution adjusts the conversion price of outstanding preferred stock to that of the stock being sold in the new offering, thereby putting the existing investors in the same position they would have been in if they had purchased their shares at the new, lower price per share. This type of anti-dilution protection is extremely favorable to the investor and should be resisted by the company in favor of weighted average anti-dilution. If you receive a term sheet with a full-ratchet anti-dilution provision, it should be a red flag that the rest of the terms may be heavily investor favorable. Fortunately, most investors do not seek to impose full ratchet anti-dilution.
Weighted average anti-dilution reduces the conversion price of outstanding preferred stock in a proportionate manner taking into account both the number of shares being issued and the price per share. In this way the conversion ratio is adjusted to somewhere between the original ratio and the ratio that would apply after full ratchet anti-dilution protection. Weighted average anti-dilution may be either “broad” or “narrow” depending on whether certain derivative securities (such as options and warrants) are included in the calculation of the company’s existing capital, with a “broad” formula resulting in less dilution adjustment (i.e., more company favorable) than a “narrow” formula. The NVCA term sheet presents a typical broad based anti-dilution formula: the number of shares outstanding for purposes of the formula (the “A” variable in the NVCA term sheet) includes not just common stock actually outstanding and common stock issuable on conversion of outstanding preferred stock, but also common stock issuable upon exercise of outstanding options. The formula could be made broader by, for instance, including all shares of common stock that may be issued out of the company’s option pool (not just those covering option already granted). The formula could be made narrower by, for instance, only including common stock issuable upon exercise of outstanding options that have vested. In negotiating the term sheet, remember that while the breadth of a weighted average anti-dilution formula does matter, it is much less important than the choice between weighted average and full ratchet anti-dilution.
Regardless of the type of anti-dilution protection, the Charter typically includes a number of exceptions allowing a company to issue additional shares in specified circumstances without any adjustment to the conversion price of the outstanding preferred stock. The NVCA term sheet includes standard exceptions for (a) shares issued upon conversion of convertible securities (conversion does not result in further dilution), (b) stock splits, dividends and the like pertaining to the company’s common stock (pro rata adjustments for these events are provided for in the Optional and Mandatory Conversion provisions), (c) equity incentives for employees and others (i.e. shares issued out of the company’s option pool) and (d) shares issued in certain types of transactions. It is also common, and generally good for the company, to include a provision allowing X% of the investors to waive anti-dilution protection on behalf of all investors (again, the percentage required is typically the same as for approving matters subject to the protective provisions or compelling a mandatory conversion).
Of course, the best way to avoid the double-dilution created by anti-dilution provisions is to keep growing the value of your company so the stock price keeps rising. Herein lies an important lesson about negotiating valuation in a financing: a higher valuation increases the probability of a future down-round financing, so it may be better to accept a lower valuation that you are confident you can improve before you’ll next need to raise capital.