Anatomy of a Term Sheet 7 — Conversion

Welcome back for another installment of our Anatomy of a Term Sheet series. We are taking the model Series A term sheet from the NVCA, and analyzing the various terms in depth. The goal is to give startup founders a solid understanding of the complex provisions of the term sheet. The next items in our Anatomy of a Term Sheet series are the terms for mandatory and optional conversions of preferred stock into common stock.A typical mandatory conversion term looks like this:

Each share of Series A Preferred will automatically be converted into Common Stock at the then applicable conversion rate in the event of the closing of a [firm commitment] underwritten public offering with a price of [___] times the Original Purchase Price (subject to adjustments for stock dividends, splits, combinations and similar events) and [net/gross] proceeds to the Company of not less than $[_______] (a “QPO”), or (ii) upon the written consent of the holders of [__]% of the Series A Preferred.

“QPO” is shorthand for Qualified Public Offering. 

With this term, the preferred stock converts automatically if there is an IPO at a specified level, or if a specified percent of the preferred stockholders consents. There are two triggers for an IPO mandatory conversion – the amount raised and the price per share. The amount raised is typically set at a high enough level to ensure that it is a legitimate IPO. This protects the Series A investors in the case of an IPO that raises very little money, because there is probably not going to be a very liquid market for the stock.

In negotiating the price per share trigger, the founders should push for a lower multiple, such as 2X or 3X, to give them more flexibility with an IPO. Also, “gross proceeds” of the IPO is more favorable to the founders than “net proceeds.”

Optional conversion looks like this:

The Series A Preferred initially converts 1:1 to Common Stock at any time at option of holder, subject to adjustments for stock dividends, splits, combinations and similar events and as described below under “Anti-dilution Provisions.”

There may be situations where it is more advantageous for the preferred stockholders to convert their shares to common stock. For example, assume that the Series A investor has a $2 million investment in the company with a 2X non-participating liquidation preference, representing 30% of the outstanding stock. If the company is sold for $50 million, the investor gets $4 million off the top due to the liquidation preference, and the remaining $46 million is distributed among the common stockholders. If the Series A investor chooses to convert its preferred stock to common, giving up its liquidation preference, it gets $15 million. The optional conversion term is designed to give the Series A investors this flexibility.

Next time we will look at the anti-dilution provisions. 

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