What is a shadow series and how is it used in convertible note and SAFE financings?

Takeaway: Shadow series of preferred stock are series of preferred stock that are identical in all ways to the series of preferred stock issued to cash purchasers in a financing except for the per share liquidation preference, which is keyed to the conversion price of their note/SAFE, and the per-share dividend rate. It is used to ensure that investors holding convertible notes or SAFEs don’t get a windfall when their note/SAFE converts. For example, if a SAFE converts at $0.80 per share and a company sells preferred stock at $1.00 per share, assigning the SAFE holder the same $1.00 liquidation preference would give them a windfall - their liquidation preference should be $0.80 per share.

When convertible promissory notes and SAFEs convert into stock of a startup (usually in a fundraising round), they typically do so at a price that is lower than the price the new cash investors pay in the financing. The issue this creates is that the convertible promissory notes and SAFEs are converting at a lower price but are receiving the same type of shares as the new cash investors, which gives the holders of convertible promissory notes and SAFEs a windfall.

For example, if a startup sells shares of its Series A Preferred Stock at $1.00 per share and the convertible promissory notes and SAFEs convert into the same Series A Preferred Stock at a 20% discount, they would convert at $0.80 per share. Down the road, let’s say that the startup agrees to be acquired but the sale price isn’t great and the Series A investors end up taking their liquidation preferences (i.e., they get the amount they invested back before any common stockholders get any proceeds). In this situation, the new cash investors in the Series A get $1.00 per share for the $1.00 per share that they paid to acquire their stock. The convertible promissory notes and SAFEs, however, get the same $1.00 per share but they only “paid” $0.80 per share to acquire their stock. The difference between what the cash investors paid and what the holders of convertible promissory notes and SAFEs paid (in this example, $0.20) is a windfall to the holders of convertible promissory notes and SAFEs. This windfall isn’t fair both to the new cash investors and to the common stockholders (i.e., founders and employees) because the holders of convertible promissory notes and SAFEs end up taking more than their share of the sale proceeds.

One way we avoid this windfall is to use what is called a shadow series of preferred stock. In this post, we will explore what a shadow series of preferred stock is and how it can be used in conjunction with convertible promissory notes and SAFEs to ensure that everyone is treated fairly when the convertible promissory notes and SAFEs convert.

What is a Shadow Series of Preferred Stock?

A shadow series of preferred stock is a series of preferred stock issued by a startup company that is identical in always to the series that it shadows except for the amount that the holders of such shadow series are paid in connection with dividends and their liquidation preference. Except for the dividends and liquidation preference, the rights, preferences, and privileges of the shadow series are essentially the same as the existing series of preferred stock, effectively creating a "shadow" of the original series. Startups very rarely pay dividends so the primary purpose of a shadow series is to ensure the liquidation preference is structured equitably.

Shadow series are usually denominated with a number - e.g., Series A-1 Preferred Stock would be a shadow series of Series A Preferred Stock. If there are multiple convertible promissory notes or SAFEs with different conversion prices (due to different discounts or valuation caps), there may be multiple shadow series (e.g., Series A-1 Preferred Stock, Series A-2 Preferred Stock, etc.).

Key Considerations for Startups and Investors

When contemplating the use of a shadow series of preferred stock in conjunction with convertible promissory notes or SAFEs, startups and investors should consider the following factors:

  • Cleanliness of Capitalization Table: Shadow series of preferred stock are typically a very good solution to the windfall problem unless there are convertible promissory notes and SAFEs converting at too many conversion prices. Having a cap table with 10 shadow series becomes administratively difficult.

  • Documentation: The conversion mechanism of convertible promissory notes and SAFEs into shadow series of preferred stock should be clearly defined and documented in the convertible promissory notes and SAFEs. It is easiest to do this up front because holders of convertible promissory notes and SAFEs are often resistant to giving up this windfall later.

Conclusion

Shadow series of preferred stock are a good solution most of the time to the windfall issue created by convertible promissory notes and SAFEs having a different effective purchase price for preferred stock than cash investors. It is essential to engage experienced legal counsel to ensure properly negotiate and document the terms of the shadow series and its relationship with the convertible promissory notes or SAFEs.