When investing in a startup, convertible preferred stock provides investors with some protection against downside risk and gives them the opportunity to potentially benefit from the upside if there is a liquidity event, where the stock price may increase.
Preferred Stock vs. Common Stock
Before we talk about Convertible Preferred Stock, let us start with the basics of Preferred Stock and Common Stock. We have covered this in an earlier post called Preferred Stock vs. Common Stock in Startups, which discusses both types of stock and how they work in startup investing. Also covered are the benefits and rights of both types of stock. In summary:
- Common stock is the type of stock most often purchased by investors and is what most people would typically think of when it comes to stocks. A common stock is a security that represents equity ownership in the company. Holders of common stock have the right to elect a board of directors who makes the decisions for the company.
- Preferred Stock is a special class of stock and comes with certain rights. The term “preferred” comes from the preferential treatment received by holders of preferred stock, primarily being related to dividend payments, seniority (referring to an investor’s place in the payment queue), liquidation preferences (find out more in the article Liquidation preference and what it means when investing in startups), and certain other rights.
The primary difference between preferred stock and common stock is that preferred stock resembles a bond with a fixed dividend and a set redemption price, whereas common stock has greater potential for increases in the stock price but comes with uncertainty in dividends and greater risk of loss in the event of a company failure.
What is Convertible Preferred Stock?
Convertible preferred stock is a class of preferred stock that allows the holder to convert their preferred shares to common shares under certain circumstances. Convertible preferred stock allows the holder to benefit from the potential advantages of preferred stock early in the life of a company and limit their downside risk if things go bad. On the flip side, if things go well, they can convert their preferred stock to common stock and benefit from the potential upside of an increase in the price of the common stock. It could be thought of as a way to have your cake (risk mitigation) and eat it too (potentially benefiting from stock price appreciation).
Convertible preferred stock can be thought of as a hybrid security, comprising elements of both debt and equity. The debt component comes with the fixed dividend payments and seniority in the payment queue, whereas the equity component comes in with the option to convert to common stock. If things go well with the startup, at some stage the price of the common stock may rise above the price of the preferred stock. At this stage, there may be merit in considering the conversion of preferred stock to common shares (more on that later).
It is important to remember that once holders of preferred stock convert their shares, they give up the rights that come with being a preferred shareholder (such as no seniority and no fixed dividend).
Convertible Preferred Stock Terms to Know
Some terms that are often used in the context of convertible preferred stock include:
- Conversion Ratio: This is the number of common shares that the holder of convertible preferred stock would receive for every preferred share tendered for conversion. For example, if the conversion ratio was five, the holder of preferred stock would receive five common shares for every preferred share they own. Note this ratio is pre-agreed at the time of issuing the convertible preferred stock.
- Par Value: This is the share price of the preferred stock and is the value the holder would be owed in a liquidation event.
- Conversion Price: This is the share price at which the preferred stock can be converted to common stock. The conversion price is calculated by dividing the par value of the preferred stock by the conversion ratio. For example, if the par value of the preferred stock is $50 and the conversion ratio is 5, the conversion price would be $10.
- Conversion Premium: This is the dollar value of the convertible preferred stock above the current market value of the converted common stock. For example, if the share price of the preferred stock was $50 and the share price of common stock was $8 with a conversion ratio of 5 (representing a value of converted common stock of $8 x 5 = $40), then the conversion premium would be $50 – $40 = $10.
What Are The Investing Benefits of Convertible Preferred Stock?
The investing benefits of preferred stock are summarized above and described in our aforementioned article Preferred Stock vs. Common Stock in Startups. In addition to those benefits, convertible preferred stock includes another important advantage – it can be converted to common stock if the financial conditions favor it. Holders of preferred stock receive fixed dividend payments that do not increase over time. Holders of common stock could receive dividend payments higher than those paid on preferred stock. Also, the share price of common stock may rise above that of preferred stock. The potential for these favorable financial conditions benefit the holders of preferred stock because at the appropriate time, they can convert their preferred stock to common stock. Note that the price of preferred stock can fluctuate over time, potentially rising or falling depending on the performance of the company.
Investing Disadvantages to Convertible Preferred Stock
A potential disadvantage of convertible preferred stock is their dividend payments may be slightly lower than that paid to holders of non-convertible preferred stock. The reason for this is the inherent value associated with convertible preferred stock that allows the holder the ability to convert to common stock.
When & Why Would Preferred Stock be Converted to Common Stock
In the early stages of a startup, the value of preferred stock is higher than common stock, because preferred stock comes with benefits for investors. When there is a liquidity event such as an Initial Public Offering (IPO) or acquisition, holders of preferred stock have the option to participate via their conversion rights (or they may be required to participate if the convertible preferred stock agreement contains a compulsory conversion clause in the event of an IPO).
If the liquidity event is not favorable enough, and investors have the choice available (i.e. they are not required to convert by a compulsory conversion clause), they will want to retain the seniority and protection that comes with preferred stock. If the liquidity event is favorable (with upside), preferred stockholders will likely want to convert to common stock.
How Timeline Affects Potential Earnings & Dividends Associated With This Investment
In startup investing, common stock has value at the time of exit, because that is what is sold at the time of a liquidity event. At that time, if the value of common stock is higher than preferred stock, investors will convert. It is important to understand that the crossover point when the value of common stock exceeds that of preferred stock could potentially happen early in the life of the startup. However, because startups are risky and there may be no immediate payoff or gain by converting, it can be more beneficial to hold onto preferred stock as long as possible. This way, the investor could retain their stock preferences for protection against downside risk and to benefit from all the other advantages of preferred stock.
In general, it makes sense to wait for a favorable liquidity event to convert, if they have that choice. The graph below illustrates the concept of conversion timing in a hypothetical example of a startup going from the initial issuance of convertible preferred stock to a liquidity event four years later.
At the time of the capital raise, the value of the convertible preferred stock is greater than that of the common stock multiplied by the conversion ratio. Over the first three years of operation, the hypothetical company does well, and the value of the preferred stock increases at a steady rate, while the value of the common stock increases at a faster rate but from a lower base. Just after the three-year mark, the value of the common stock increases even more rapidly, and a crossover point is reached where the value of the common stock times the conversion ratio overtakes the value of the preferred stock.
However, the holder of the convertible preferred stock chooses not to convert at this point because the common stock may still be illiquid (even though its value may be higher on paper than the preferred stock) and the investor wants to retain the protection provided by their preferences. After the crossover point, this hypothetical startup continues to do well and progresses to a liquidity event, and the value of the common stock continues to rise. Just before the liquidity event, the investor chooses to convert because they know this is the time of liquidity, when there is a market ready and willing to buy the common stock.
In this example, the investor held on to their preferred stock for as long as possible to maximize his protection and only converted when he was sure that he could sell his common stock.
Note that agreements for convertible preferred stock may include a mandatory requirement forcing investors to convert to common stock in the event of an Initial Public Offering. Automatic conversion clauses often include threshold values for share price and total proceeds before triggering the conversion.
When to Keep Preferred Stock
An investor would keep his convertible preferred stock if the value of it is greater than the value of the common stock if converted. Due to the fact that protection and benefits of preferred stocks are still an advantage, an investor may choose to not necessarily convert at the crossover point immediately.
Because of the risky nature of startups, there is always a chance that things could go bad, and the company could go bankrupt or never make it to a liquidity event. If the company does go down, the holders of preferred stock can exercise their liquidation preference, giving them the right to receive funds before common stockholders (which often includes the founders and employees of the startup).
How Convertible Preferred Stock Impacts Start-Ups
The use of convertible preferred stock as a capital-raising tool provides a number of advantages for startups, because of its hybrid nature comprising elements of both debt and equity. Unlike specific debt instruments, this form of stock provides clarity around valuation and ownership and also prepares the startup for future fundraising by starting the valuation process early in the life of the startup (Which is not always the case when using only debt instruments).
Another key benefit of convertible preferred stock is that it can help to attract investors.
Convertible preferred shares can be attractive for investors because its hybrid debt / equity nature provides potential advantages that can mean the best of both worlds – protection against downside risk, and potential to profit from the upside if a favorable liquidity event occurs.
If you are interested in building your portfolio by adding investments in startups, you can find more information here on how to start angel investing and how to find opportunities for angel investing on the Propel(x) platform.
As with any investment, past performance is no guarantee of future performance, and any investment decision must balance the risk against the potential return. Private investments are highly illiquid and risky and are not suitable for all investors. There is no guarantee that a liquidity event will ever take place.