VW Blog

Liquidation Preferences and Convertible Notes

June 29, 2015   |   By Aaron Terwey

It’s no secret that entrepreneur-turned-VC, Mark Suster, generally isn’t a fan of convertible notes. Here at Vela Wood, we’re fairly pro convertible notes when used responsibly in certain situations. Despite Suster’s dislike of convertible notes, he still looks out for entrepreneurs who insist on using them. To that end, a few weeks ago, Suster wrote about one simple paragraph every entrepreneur should add to their convertible notes.

The gist of Suster’s piece is that if, following a convertible note investment, a company raises a priced round that exceeds the conversion cap, without language in the convertible note documents that limits the converted noteholders’ liquidation preference, the company could find itself giving the converted noteholders more than the liquidation preference negotiated by and given to the priced round investors.

We don’t want to go too far into liquidation preferences here, but to put it simply, an equity holder with a liquidation preference gets paid first in the event of a liquidation/exit. This is downside protection for the investor – investor A says I’ll invest $500k at a $4.5M pre-money valuation, but if you sell the company at a valuation of less than $5M, I get my $500k back first.

What Causes Increased Liquidation Preferences

A liquidation preference is typically tied to the original issue price of stock. If, following a convertible note round, the company’s valuation at the next priced round is greater than the convertible note conversion cap, the noteholders will convert into a number of preferred shares that is greater than the number into which they would have converted in the absence of the conversion cap.

That’s all well and good, except for the fact that without the proper language in the convertible note documents, those preferred shares would have an original issue price equal to the price per share that the priced round investors paid, rather than an original issue price equal to the effective price per share paid by the converted noteholders resulting from the conversion cap.

This combination of the converted noteholders having more preferred shares with a higher original issue price than that effectively paid by the converted noteholder results in the increased liquidation preference for the converted noteholders. Or simply put, a noteholder putting in $100 could be entitled to a liquidation preference of $150, which will kill all other equity shareholders in the event of a sale that triggers the liquidation preference.

The Solutions

As José Ancer points out, there are two common alternatives to solving this issue. The first is by having the notes convert into a combination of preferred and common shares such that the liquidation preference on the preferred shares would equal the noteholders’ initial investment and common shares for any remaining shares to which the converting noteholder is entitled. While this effectively limits the converted noteholders’ liquidation preference to that which they should actually receive, the process seems clunky and not as clean as the second option.

The second option is creating a parallel series of preferred stock into which the noteholders would convert. This parallel series of preferred stock is identical to the preferred stock that the priced round investors receive in all respects except that the original issue price of the parallel series of preferred stock accurately reflects the effective price per share paid by the converted noteholders and thus limits the converted noteholders’ liquidation preference to the negotiated amount.

Several clients sent Suster’s piece to us, concerned that perhaps their convertible note docs didn’t have the requisite language necessary to ensure that they don’t give up a 5x (or more) liquidation preference to noteholders. Fear not, while our opinion of convertible notes may differ from Suster’s, we definitely agree with his point about the risk of entrepreneurs getting screwed, whether intentionally or unintentionally, by the liquidation preference, that’s why our convertible note docs have (and have had for some time) language that protects our clients from accidentally giving noteholders a greater liquidation preference than the next priced round investors receive.

Posted in Convertible Notes, Funding & Capital Raising, Startups
Aaron Terwey
Aaron Terwey is a senior associate at Vela Wood. His practice is focused on representing investors and startups in venture financing transactions and mergers and acquisitions. You can see Aaron's attorney profile here.