Convertible Preferred Shares:
Like common shares, convertible preferred shares represent ownership in the company. However, they are more advantageous than common shares from the perspective of investors given that convertible preferred shareholders are entitled to higher priority upon liquidation than holders of common shares, especially in the context of such high-risk investment as investing in a startup.
On the other hand, convertible preferred shares are more welcomed by venture capitalists and angel investors as compared with convertible notes or SAFE. The reason is that these investors are usually provided with additional investor protections.
Convertibility:
Convertible preferred shares can be exchanged for a pre-determined number of common shares at a later day, allowing investors to swap their fixed-income interest for potential capital gains.
It comprises both optional and mandatory conversion rights. It could be optional in the sense that investors can convert their preferred shares into common shares at any time. At the same time, it could be mandatory that preferred shares would be converted to common share upon the occurrence of the following events:
- The Company undergoes a qualified initial public offering: Usually there would be minimum thresholds for the IPO’s (a) price per share and (b) amount of company proceeds before the conversion is triggered.
- Conversion results in an economically superior outcome for the preferred shareholders: when conversion to common shares would lead to increased value for the investor in the event of liquidation or acquisition.
Some Common Terms in the Preferred Shares Agreement:
- Financial Terms of the Investments
- Pre-money valuation
- Amount of capital to be raised
- The size of the stock option pool (for employees) (if applicable)
- Number of shares to be issued
- New Investor’s Rights in the Company
- Voting Rights
- relatively common for startups
- unfavourable to existing shareholders
- Corporate Governance (possible but relatively uncommon)
- Lead investors may require at least one seat at the startup’s board of directors
- Anti-dilution Provisions:
- Protect investors from losing value in subsequent financing rounds by adjusting the price at which preferred shares converts to common shares
- Liquidation Preferences:
- Dictate how proceeds from a liquidation or acquisition will be distributed
Pros of Convertible Preferred Shares:
- Certainty about valuation:
- Valuation in a convertible preferred share agreement is attached to the company and each share’s price
- Certainty about ownership:
- cap table could be updated accordingly because the number of shares, whether preferred or common, would be ascertainable before the equity round
- C.f. convertible notes: no certainty about the updates in the cap table
- May be able to attract more investors:
- As compared with safe and convertible debt, convertible preferrable shares are more favourable to investors.
Cons of Convertible Preferred Shares:
- More complex
- Other than providing for the mechanism to convert preferred shares to common shares, more shareholder rights shall be conferred to investors
- Founders must calculate and evaluate the potential impact of the preferred shareholder rights in conjunction with the price per share (valuation)
- Time and monetary costs would likely be higher
- Given the effects of the equity conceded and the shareholder rights conferred to investors, more negotiation would be needed and it might take a longer period of time before founders and investors could reach an agreement on such rights conferred and other terms in the agreement
- Given the length and the complexity of the documents needed, it might be necessary to amend and restate the company’s articles of association, which would be more time-consuming and costly