Most convertible notes have a price cap as a feature term. Depending on the delta between the price cap and the pre-money valuation of the qualified equity financing, the convertible note investors could receive a windfall in terms of liquidation preference. That is, the investor’s liquidation preference could exceed its original investment amount.
The Potential Problem
Let’s say Series A investors invest at a pre-money valuation that equates to a $1.50 per share purchase price of a startup’s Series A Preferred Stock. And due to a price cap, the convertible note investors get to use their debt to purchase the same Series A Preferred Stock at $0.50 per share. Assuming the Series A Preferred Stock comes with a 1X non-participating liquidation preference, and without a windfall regulator, the convertible note investors would receive a liquidation preference equal to 3X their investment since the liquidation preference of Series A Preferred would be drafted as “$1.50 per share of Series A Preferred Stock”.
The Multiple Series of Preferred Stock Approach
One approach to combat this potential windfall for the convertible note holders is to split the Series A Round into two different equity securities, such as Series A-1 Preferred Stock & Series A-2 Preferred Stock.
The only difference between the Series A-1 Preferred Stock and the Series A-2 Preferred Stock would likely be the per share prices/amounts listed in the company’s amended and restated certificate of incorporation. For example, the liquidation preference could be drafted as “$0.50 per share of Series A-1 Preferred Stock; $1.50 per share of Series A-2 Preferred Stock.” However, if the term sheet calls for a specific dividend rate, then the dividend rate would also be different for the Series A-1 and the Series A-2. In most cases the Series A-1 and Series A-2 would vote together on all matters and not separately.
The Combination of Preferred Stock and Common Stock Approach
The other common way to regulate the liquidation preference windfall is to have only the Series A Preferred Stock (i.e., no A-1, A-2) with the convertible note holders and Series A investors purchasing Series A Preferred Stock at the same price. In order to give the convertible note holders the benefit of the price cap, the company would issue common stock to the convertible note holders in an amount that would get the average purchase price (when factoring in the total amount of Series A Preferred Stock and Common Stock issued to a convertible note investor) equal to the price cap per share price.