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Conversion rights refers to the shareholder’s ability to convert the preferred shares into common shares. Conversion rights are important as they affect the calculation of other rights of shareholders. Most calculations use the number of outstanding shares “on an as-converted basis”. This means that the total number of stock is calculated by including the shares into which preferred shares would convert. “Conversion rights come in two forms: optional and mandatory.
Mandatory conversion, as the name implies, mandates conversion of the preferred shares into common shares upon certain events. Generally, the key event is the initial public offering of the company’s shares. An IPO of a pre-determined total value and a per share value will trigger the conversion. This is generally defined as a “Qualified IPO” in the articles of incorporation. The per share amount of the IPO will generally be a multiple of the price paid for the preferred shares (e.g., 5x in series A financing or 3x in later financing). In this case, the public offering is difficult to undertake (investors don’t like it) when there is an outstanding class of preferred shares that is not the subject of the public offering.
Option conversion is the shareholder’s right to convert the preferred shares into common shares when the result is more advantageous to the shareholders. Such is the case when the buyout of the converted common shares will yield a higher return that the return afforded the preferred shares. This situation frequently arises when there is a low liquidation preference multiple, a cap on participation rights for the shareholder, and the company sells for a large amount.
- Example: The series A investor invests $100 and receives preferred shares with a 2x liquidation preference (no participation rights) and equaling 20% of the business. If the company sells for $1,500, then the preferred shares are worth $200. The common shares, however, are worth $300 (20% of $1,500).
- Note: Generally, the optional conversion will take place upon a majority or super-majority vote of the shareholders of the preferred class of shares. Investors in different classes of shares will vote separately and will have differing levels of motivation to convert their shares.
The conversion ratio determines the number of common shares into which the preferred shares convert. The ratio is determined by taking the price of the preferred shares at the time of purchase as the denominator (on bottom) and the price of the common shares as the numerator (on top). For example, you pay $5 for a preferred share and the price of a common share is $1. The conversion ratio of preferred to common shares will be 1:5. The conversion rate is generally set at 1:1 at the time of issuance (e.g., $1 for $1).
The conversion ratio is subject to change. Any time new shares are issued, the existing shareholders will be subject to dilution. The addition of more preferred shares or common shares will dilute the preferred shareholder as the total number of shares increases. It is common to have anti-dilution protections that adjust the conversion ratio to counteract the effect of dilution through new issuances. See the Anti-dilution provision material for more information on the affect of different types of dilution protection on conversion ratios. If the new price for the preferred shares is reduced downward (say $4), then it automatically affect the conversion ratio (1:4, rather than 1:5).
- Example: Preferred shares are issued at $1, which is also the price for common shares, for 1000 shares. The conversion ratio is 1:1. After dilution in the next round of financing, the price of conversion of the new series of preferred share is $.50. The conversion ratio on the original issuance of preferred shares will change to 2 (1 divided by.5). The 1000 shares will convert into 2000 shares.
Sample Conversion Language
Automatic Conversion: 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.
Optional Conversion: 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.”