Convertible Note Liquidation Preference Overview

Convertible note liquidation preferences are the terms that define in what order shareholders will be paid should their convertible notes be liquidated at a liquidation event. Although all investors would like to have a higher liquidation preference, early investors are generally given liquidation preference over later investors due to their shouldering of greater risk at the outset.

Convertible Note Valuation

The convertible notes themselves are financial instruments regularly used to raise capital in the early stages of a company’s life. These notes commonly have a valuation cap that sets the maximum value that the note can be converted to in subsequent financing rounds regardless of the value set in that particular financing round. Such notes are meant to reward older investors by letting them convert their notes into equity at a lower price than that of so-called “new money” investors.

If a note is set with a low valuation cap, this could result in a new round of financing with a value that exceeds that of the cap, which will, in turn, allow early investors to get a liquidation preference that was much higher than was intended. This means that the investors will, in fact, receive more money than the founders of the company. This occurs more often with companies that have more difficulty in raising funds, as they have little leverage for negotiations in this regard.

This problem has become even worse recently, with the evolution of convertible notes from short-term bridge loans to long-term loans that may last several years. This lengthening of the time frame increases the risk of greater changes in the valuation of the note over the length of the loan. The resulting problem–investors being owned too large a payout–can be avoided with careful planning at the outset, otherwise, the only other recourse is to ask investors to yield some of their rights, which is never popular.

Convertible Note Liquidation Preference Terms

Some important terms to know when dealing with convertible note liquidation preferences include:

  • Conversion cap. This refers to the maximum value a company may have while the note’s owner can still convert it into shares, regardless of the company’s actual value. A note may be converted at a triggering financing event.
  • Conversion discount. This lets a convertible note holder pay a lower price for each share when converting them into shares in the triggering financing event. Investors who participate in triggering financing events have usually purchased preferred stock of the company at hand. Preferred stock will usually permit the holder to convert it into common stock at any time so long as certain terms are met.
  • Liquidity event. This is an event that in turn triggers a payout for investors. Such events could include an initial public offering (IPO) or an acquisition.
  • Liquidation preferences. This refers to the contract terms that determine who will get paid what and in what priority in a liquidity event. The two types of liquidation preferences are non-participating and participating.
  • Non-participating liquidation preference. This type of preference gives liquidation preference to preferred stockholders over common stockholders equal to the price they paid per share or some multiple of the share price. With this, shareholders have the choice to convert their shares into common shares if they want. If they do not convert, then they will be paid the amount of their note plus interest before common shareholders may gain any proceeds from the liquidity event. If they do convert, then they will be paid what was loaned to the business first with interest, then share in any gains made by the liquidity event on a pro rata basis.
  • Participating liquidation preference. This type of preference is the same as a non-participating preference, except that in this case the holder of the preference, should they convert, will be paid what was loaned to the business first with interest, then a pro rata share of the common stock profits before other distributions are doled out to any remaining shareholders. Normally, there is a 1:1 conversion ratio between preferred and common stock, although this could be higher pending negotiation.

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