Why is preferred stock convertible into common stock?
Takeaway: Preferred stock is convertible into common stock so that investors can vote with the common stock if desired and they can participate pro rata in proceeds in acquisitions. Votes around the structure of the company’s board of directors are typically set up to insulate the common stock from preferred stock converting to common stock and diluting their votes.
When venture capital (VC) investors invest in startups, they typically receive preferred stock rather than common stock. One key feature of preferred stock is its convertibility into common stock. Understanding the rationale behind this convertibility is essential for both startups and investors, as it can significantly impact investment returns and the dynamics of a company's capital structure. In this post, we will explore the reasons why preferred stock held by VC investors is convertible into common stock and how this convertibility benefits both parties.
The Convertibility of Preferred Stock
Convertible preferred stock allows VC investors to convert their preferred stock into common stock at a predetermined conversion ratio. This conversion feature provides investors with the option to participate in the equity upside of the company, should it perform well, while still maintaining the benefits of preferred stock, such as dividend rights and liquidation preferences.
Reasons for Convertibility
There are several reasons why VC investors opt for convertible preferred stock when investing in startups:
Upside Potential: Convertible preferred stock provides investors with the opportunity to participate in the equity upside of the company. If the company performs well and the value of its common stock increases significantly, investors can convert their preferred stock into common stock to capture a greater return on their investment. This aligns the interests of investors and founders, as both parties benefit from the company's growth and success.
Downside Protection: In addition to upside potential, convertible preferred stock also offer downside protection for investors. If the company does not perform well and the value of its common stock declines, investors can choose not to convert their preferred stock and instead benefit from the preferred stock's liquidation preferences and dividend rights. This downside protection helps to mitigate the risks associated with investing in startups, which often have a higher likelihood of failure compared to more established companies.
Improved Governance: Convertible preferred stock often grant investors certain governance rights, such as the ability to appoint board members or approve key corporate actions. These rights enable investors to actively participate in the company's decision-making process and help ensure that the company's strategy aligns with their interests.
Flexibility in Exit Scenarios: Convertibility provides investors with additional flexibility in exit scenarios. In the event of an IPO, merger, or acquisition, investors can choose to convert their preferred stock into common stock, depending on the specific terms of the exit and the potential return on investment. This flexibility can be particularly valuable in optimizing investment returns and managing risk.
Benefits for Startups
While convertible preferred stock primarily serve to protect and benefit investors, there are also advantages for startups in issuing convertible preferred stock:
Attracting Investment: The combination of upside potential and downside protection provided by convertible preferred stock can make startups more attractive to VC investors. By offering convertible preferred stock, startups can potentially secure investment from a broader range of investors, enabling them to raise the necessary capital to grow and scale their businesses.
Aligning Interests: Convertible preferred stock helps to align the interests of investors and founders, as both parties stand to benefit from the company's success. This alignment can foster a more collaborative and productive relationship between startups and their investors, contributing to the company's long-term success. It should be noted, however, that there are many situations in which the incentives of investors and the company can diverge - issuing convertible preferred stock does not solve all of these divergences.
Conclusion
The convertibility of preferred stock is a key feature that benefits both VC investors and startups. By offering upside potential, downside protection, improved governance, and flexibility in exit scenarios, convertible preferred stock provides a balanced investment structure that aligns the interests of investors and founders, ultimately contributing to the growth and success of the company. As with any investment decision, it is important for startups and investors to carefully consider the terms and structure of convertible preferred stock to ensure it meets their respective objectives and expectations.