In this post in our key term sheet provisions series, we’re discussing conversion rights.
Investors’ preferred stock is always subject to an optional conversion into common stock. That is, they can convert their preferred shares into common shares at any time. This is a standard provision that will be found in 99.9% of all term sheets; it’s one of the few terms that are actually nonnegotiable. The conversion is usually on a 1:1 basis, which tends to undervalue preferred shares as they have additional features which make them “preferred” to common stock. Notably, preferred shareholders lose their liquidation preference when they convert to common stock. Once preferred has been converted to common, it can’t be converted back to preferred.
So why would preferred shareholders want the option to convert their shares into common stock? There are two primary instances when preferred shareholders elect to convert their stock. First, depending on the terms of their liquidation preference, it may be financially beneficial to convert to common stock prior to a sale of the company. Second, preferred stock often doesn’t have the same voting rights as common, and preferred shareholders may wish to convert to acquire these voting rights.
Generally there is a second conversion provision which provides for the automatic conversion of preferred stock into common upon the occurrence of a particular event. The usual event that triggers automatic conversion is an initial public offering. It is unusual for companies to go public with multiple classes of stock (although Google did) and the IPO process is generally easier if there is only one class. Thus, founders often negotiate for automatic conversion provisions. Investors will want the thresholds to automatic conversion to be higher (the stock will automatically convert only if the IPO price is a higher multiple of the original purchase price), so that they have more control over the conditions under which the company will go public. And conversely, the founders want lower thresholds so that they have greater flexibility in planning the IPO. If there are multiple classes of stock it is important that they have the same threshold to automatic conversion, or else one class may end up with what amounts to a veto right.