An Unintended Outcome from Convertible Notes and Convertible Equity
Using a convertible note or convertible equity, like a SAFE, for your seed round is very popular due to the speed in which you can close the round, and the low legal costs associated with it. However, be warned. Convertible notes and convertible equity instruments can lead to some unintended consequences when they convert during your next equity financing round. A major one that I have seen is the convertible note or equity holders receiving a liquidation preference that is off-market. The purpose of this post is to highlight this unintended consequence so you and your co-founders are not blindsided, and to offer a couple suggestions on how to mitigate it.
Off-Market Liquidation Preference
As I described in a previous post, the convertible note or equity holders do not pay the full price per share that your Series A investors are paying. They usually get a 20% discount off the price per share in this round. While this discount is intended, what isn’t intended is the convertible note or equity holders receiving a greater than 1x liquidation preference.
Liquidation Preference: This is the amount of money the investors will receive back from the company upon a liquidation event (sale, IPO, etc.). The normal liquidation preference is 1x. This means that the investors will receive at least the amount of their investment back before the common stockholders receive any of the proceeds from the sale of the company or other liquidation event.
So how does the discount equate into a higher than normal liquidation preference? As mentioned previously, when the convertible notes or equity convert, the holders receive the same Series A stock as the Series A investors. Normally the Series A investors have a 1x liquidation preference. If the convertible note or equity holders have a 20% discount into this round, then they would get a 1.25x liquidation preference. For example, let’s say your Series A price is $1 per share. The convertible note or equity holders would receive the Series A shares at a price of $0.80 per share due to the 20% discount with a 1x liquidation preference on stock worth $1 per share. This results in a 1.25x liquidation preference ($1 of liquidation preference divided by the $0.80 conversion price equals a liquidation preference that is 1.25x the amount the convertible note or equity holders invested).
While this may not sound like much or that big of a deal, if the Series A round that triggers the conversion is significantly above the valuation cap on the convertible notes or equity, it can result in a liquidation preference that is wildly off market. For example, let’s say your Series A pre-money valuation is $20 million and the convertible note or equity valuation cap is $5 million. Let’s further assume that your Series A price per share is $4 and the fully diluted capitalization used to calculate both the convertible note or equity price and the Series A price is 5 million shares. Based on these assumptions, the convertible note or equity conversion price calculated using the $5 million valuation cap would be $1.00 per share ($5 million divided by 5 million shares). This amounts to a 4x liquidation preference ($4.00 of liquidation preference divided by the $1.00 conversion price). This 4x liquidation preference is a wildly off-market term for a Series A round and can happen when there is a significant spread between the valuation cap in the convertible notes or equity instruments and the pre-money valuation in your Series A round.
How To Handle The Situation
There are 2 ways to account for such an issue upon conversion: 1) issuing shadow preferred stock; or 2) providing a discount in common stock.
Shadow preferred stock: With this method you draft the convertible notes or convertible equity documents to give the holders a separate series of preferred stock at a next equity financing. Upon the conversion of the note or equity at your Series A round, the convertible note or equity holders receive Series A* stock instead of the Series A stock issued at that round. The Series A* stock has a liquidation preference that matches the dollar amount invested in that convertible note or equity on a 1:1 basis; ensuring that they have a 1x liquidation preference.
Discount in common stock: With this method, you give the holders of the convertible notes or equity enough shares of the Series A stock so that their liquidation preference matches their total dollars invested. After that, you issue the remaining number of shares to which the convertible note or equity holders are entitled to pursuant to the valuation cap or discount in the form of common stock.
As useful as the above solutions are, they also complicate the transaction and increase the legal cost. Therefore these solutions are only really necessary if you feel the valuation cap is set unrealistically low and/or the amount raised through your seed round is large enough to justify the increased cost.