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For the past couple of months, I’ve been exploring some of the more confusing terminology in VC term sheets.  In my last post, I discussed “pay-to-play” provisions, which are designed to provide a strong incentive for investors to participate in future financings.  Today, I’m taking a look at the conversion rights of the investors.

What are conversion rights? As you likely know, VC investors are typically issued shares of preferred stock, not common stock.  Preferred stock, as the name suggests, is preferable to (and more valuable than) common stock because it grants certain key rights to the holders, one of which is conversion rights.

A conversion right is the right to convert shares of preferred stock into shares of common stock.  There are two types of conversion rights: optional and mandatory.

Optional conversion rights – Optional conversion rights permit the holder to elect to convert its shares of preferred stock into shares of common stock, initially on a one-to-one basis.  These rights are related to the investor’s liquidation preference.

For example, let’s assume that the Series A investor has a $5 million, non-participating liquidation preference (with a 2x multiple) representing 30 percent of the outstanding shares of the company, and the company is sold for $100 million.  The investor would thus be entitled to the first $10 million pursuant to its liquidation preference, and the remaining $90 million would be distributed ratably to the common stockholders.

If the investor, however, elects to convert its shares to common stock pursuant to its optional conversion rights (thereby giving-up the liquidation preference), it would receive $30 million.

Optional conversion rights are typically non-negotiable and will look like this in the term sheet:

“The Series A Preferred initially converts 1:1 to Common Stock at any time at the option of the holders, subject to adjustments for stock dividends, splits, combinations and similar events, as described below.”

Mandatory conversion rights – Mandatory conversion rights require the holder to convert its shares of preferred stock into shares of common stock. This happens automatically and is sometimes referred to as “automatic conversion”.

Mandatory conversion rights are always negotiable and will look like this is in the term sheet (the blanks are thresholds that require negotiation, as discussed below):

“All of the Series A Preferred shall be automatically converted into Common Stock, at the then applicable conversion rate, upon (i) the closing of a [firm commitment] underwritten public offering of Common Stock at a price per share not less than ___ 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 $_______ ; or (ii) the written consent of the holders of ___% of the Series A Preferred.”

What are the key issues for founders? There are several issues founders should focus on in connection with either type of conversion rights.  First, founders should push for a low multiple of the Original Purchase Price (for example, two or three times the Original Purchase Price) to create more flexibility with regard to an IPO.

Similarly, founders should push for “gross” (not “net”) proceeds and an amount in the range of $10-15 million – or, even better, “for a total offering of not less than [$10-15] million (before deduction of underwriters’ commissions and expenses).”

Sometimes experienced counsel can persuade the investors to eliminate these thresholds entirely (to avoid the possibility of having to obtain last-minute waivers when pricing the IPO). If not, the company has to ensure the thresholds are the same for all series of preferred stock.

Finally, founders should push for a majority threshold with respect to an automatic conversion upon written consent of the Series A Preferred. And if more than one series of preferred stock is issued, the holders should be required to vote as a class (otherwise a single series could block the transaction).

(Missed previous installments in this ongoing series?  Click to learn more about the following issues:)

Startup owners: Got a legal question about your business? Submit it in the comments below or email Scott directly. It could end up in an upcoming “Ask the Attorney” column.

Scott Edward Walker is the founder and CEO of Walker Corporate Law Group, PLLC, a law firm specializing in the representation of entrepreneurs. Disclaimer: This “Ask the Attorney” post discusses general legal issues, but it does not constitute legal advice in any respect.  No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel in the relevant jurisdiction.  VentureBeat, the author and the author’s firm expressly disclaim all liability in respect of any actions taken or not taken based on any contents of this post.

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