Convertible preferred share investments

 

A convertible preferred share investment provides investors with an ownership position in the company, at a price per share agreed upon by the company and investors. However, preferred shares will include different rights than common shares, such as greater upside potential and a level of downside protection for their investment.

Preferred shares tend to be issued in series, with a separate series (A, B, C) denoting each round of investor financing. Terms are generally similar between rounds, except the later investors’ shares will rank before the other preferred shareholders and common shareholders. The preferred shares tend to include a mechanism for converting preferred shares to common shares under certain situations (e.g., a public offering of the company’s shares).

Rights may include any or all of the following :

• determination of Board composition
• voting rights
• dividend preference
• liquidation preference
• redemption right
• anti-dilution protection
• protective provisions
• pre-emptive rights
• registration rights
• right of first refusal
• co-sale or piggy-back rights
• drag-along rights
• repurchase option on founders’ shares
• setting form of employment agreements
• approving amount and terms of stock option plan

 

These types of investments appeal to the widest audience of potential sophisticated investors, including VCs, angel networks or individual angel investors who co-invest with VCs in syndicated investment rounds. This appeal may enable your business to raise the significant capital it requires. However, preferred share deals can be complex and founders/management must calculate and consider the potential impact of the preferred share rights in combination with the price per share (valuation). In some cases, a lower valuation with lower preferred share rights may yield a higher economic outcome for common shareholders than a higher valuation with a high level of preferred share rights.

VCs (and some angel investors) almost exclusively invest in preferred share deals in exchange for their significant cash investment. These investors require additional upside potential as well as downside protection from the rights of the preferred shares in exchange for the high degree of investment risk.

References

Houston, T., Johnson, A.,& Smith, E. (2006, September 15).Technology Startups: A Practical Legal Guide for Founders, Executives and Investors. Retrieved April 9, 2009, from Fraser Milner Casgrain website at http://www.techstartupcenter.com/

Canada Business. Retrieved April 12, 2009, from http://www.canadabusiness.ca.
VC Experts. Retrieved April 9, 2009, from http://vcexperts.com/vce/library/encyclopedia/documents_view.asp?document_id=1316.

Tags: equity, investors