When should preferred stock be automatically converted into common stock?
Takeaway: Preferred stock should automatically convert to common stock in an IPO and when a majority of the preferred stock votes to convert it to common stock.
Venture capital (VC) investors typically hold preferred stock in startup companies, which offers benefits such as dividend rights, liquidation preferences, and the option to convert into common stock. In some cases, preferred stock is subject to automatic conversion, which occurs under specific circumstances defined in the investment agreement. In this post, we will discuss the situations in which preferred stock held by VC investors is automatically converted into common stock and the rationale behind these conversion triggers.
Automatic Conversion Triggers
There are two main scenarios in which preferred stock held by VC investors may be automatically converted into common stock:
Initial Public Offering (IPO): An IPO is a common trigger for the automatic conversion of preferred stock. When a startup goes public, the preferred stock held by investors may be automatically converted into common stock. The startup’s charter typically defines the specific conditions under which this conversion occurs, such as a minimum offering price and a minimum aggregate offering amount. The purpose of this conversion is to simplify the company's capital structure and make it more appealing to public market investors, who are generally more familiar with common stock.
Reaching a Threshold Vote: Another trigger for automatic conversion is when the preferred stockholders vote in favor of converting their shares into common stock. This threshold vote is usually defined as a specific percentage of the outstanding preferred stock, often ranging from a simple majority to a supermajority (e.g., 66.67% or 75%). This conversion trigger allows preferred stockholders to collectively decide to convert their shares into common stock, typically in situations where the company's performance and growth prospects make the conversion advantageous for investors.
Rationale Behind Automatic Conversion
There are several reasons why automatic conversion provisions are included in startups’ charters:
Simplification of Capital Structure: As mentioned earlier, the automatic conversion of preferred stock into common stock helps simplify the company's capital structure. This simplification is particularly important in the context of an IPO, as public market investors prefer a more straightforward capital structure, which makes it easier to understand the company's valuation and ownership dynamics.
Alignment of Interests: The automatic conversion of preferred stock aligns the interests of VC investors and common stockholders, such as founders and employees. By converting their preferred stock into common stock, investors become subject to the same economic risks and rewards as other stockholders, fostering a more collaborative and supportive relationship among stakeholders.
Facilitation of Exits: In some cases, automatic conversion provisions can facilitate exits for both startups and investors. For instance, in the context of an IPO, the conversion of preferred stock into common stock can make the company more attractive to potential public market investors, ultimately contributing to a successful IPO. Similarly, the conversion of preferred stock in connection with a threshold vote can create a more favorable environment for a merger or acquisition.
Increased Liquidity: Converting preferred stock into common stock can improve liquidity for investors. Common stock is generally more liquid than preferred stock, particularly in public markets, allowing investors to more easily sell their shares and realize a return on their investment.
Conclusion
The automatic conversion of preferred stock held by VC investors is an important feature of many investment agreements. By simplifying the capital structure, aligning the interests of stakeholders, facilitating exits, and improving liquidity, automatic conversion provisions can benefit both startups and investors. It is essential for both parties to understand the triggers and implications of automatic conversion provisions when negotiating investment terms and planning for the company's future growth and potential exits.