Many early-stage startups are raising money from angel investors through convertible debt—it’s easy and well-understood, right?

Well, mostly.

There are a couple problems with convertible debt that have emerged as it has become the funding method of choice (it wasn’t always the security-de-jour). So we wanted make entrepreneurs aware of perhaps the most hidden and misunderstood issue: multiple liquidation preferences.

In a nutshell, investors in convertible debt that have a valuation cap are often getting a significantly higher liquidation preference than the cash they invested in the company—and this is ultimately coming out of the founders’ pockets and can even mess up later rounds of equity financing.

Fortunately, this is easy to fix before finalizing the convertible debt docs. Unfortunately, fixing it later can be painful; you’ll either have to go back to early investors and ask them to give up some of their rights (never popular), or you’ll end up with a messy cap table. And for startups, “cleanliness is next to godliness” should be your mantra for your cap table.

First, it’s helpful to understand why investors like convertible debt and how it has come to have certain terms. Investors like it because they get in on a (hopefully) good deal early, they don’t have to haggle with the entrepreneur much about terms (like they would leading a priced round), and they get to piggy-back on a VC or other lead investor setting the terms later (typically for Series A preferred stock). In addition, the convertible debt investors want a discount to the Series A price, since they gave you money earlier when the company was riskier—all fair and good. And if you happen to put off a priced round for a long time, and the valuation goes way up, they want more valuation gain than would be implied by their 20-30% discount—thus a cap on the valuation at conversion was born.

Second, it’s helpful to understand a few key terms:

  • A liquidity event is an event that triggers a payout to investors. It could be an acquisition, an IPO, etc.
  • Liquidation preferences are the terms determining who gets paid what—and in what order of priority—in different liquidity events.

 

The hidden multiple liquidation preference

On his blog, The Silicon Hills Lawyer, José Ancer did a great job of summing up the problem of “liquidation overhang” in the post The Problem in Everyone’s Convertible Notes. Here is his example, walking through the math of how and why early investors may get a larger payout than you’d expect:

  • $500K seed round with [convertible] notes carrying a $2.5MM valuation cap.
  • Series A has a $10MM pre-money valuation, resulting in a per share price for new money of $4.00.
  • The Series A has a run-of-the-mill 1x participating liquidation preference. This means that the Series A have a per share liquidation preference of $4.00.
  • The $2.5MM valuation cap means the notes convert at $1.00.

Under the above example, the $500K in notes will convert, ignoring interest, into 500,000 shares. ($500,000 / $1.00)

If the Notes convert directly into the same Series A preferred stock as “new money” investors get (which is what most notes require), their aggregate liquidation preference is $2 million (500,000 shares X $4.00).

So those investors paid $500,000, but they have $2 million in liquidation preference. In other words, they got a 4x participating liquidation preference.

Instead of the convertible noteholders getting the standard 1x liquidation preference that’s typical for preferred stockholders, they are effectively getting a 4x liquidation preference they never paid for. And let’s face it, you’d never knowingly give a VC a 4x liquidation preference—you’d spit in their eye and walk away. So why give it to convertible debt holders?

 

What can you do about it?

A first priced round will often be for Series A Preferred Stock. VCs insist on preferred stock for a variety of reasons. One is that they can structure a liquidation preference, meaning they get their money out before any money goes to the common stockholders. That’s all fine and normal. And today, when terms are relatively entrepreneur-friendly, you want to make sure that their liquidation preference is limited to 1x the amount of money they put in. They get their money out, and that’s all. Again, this is common practice for VC investments.

And there’s no good reason why convertible notes should be different. They have a valuation cap on the convertible debt to ensure they get the valuation increase if the company goes way up in value, so to get a “bonus” 4x liquidation preference is really double-dipping.

From a legal standpoint, there are several ways founders can protect themselves against the hidden multiple liquidation preference. We’ll review a couple of strategies briefly here, but ultimately, you need a savvy start-up lawyer that has dealt with this exact issue before.

  • Specify in the convertible note what the liquidation preference will be when the note converts. In his excellent post, One Simple Paragraph Every Entrepreneur Should Add to Their Convertible Notes, Mark Suster offers a suggestion in plain English of what you should include:

    “If this note converts at a price higher than the cap…your stock [will] be converted such that you will receive no more than a 1x non-participating liquidation preference plus any agreed interest.”

  • Issue sub-series of preferred stock. Another way founders can protect themselves against multiple liquidation preference is to write into the convertible note a clause that explains a special sub-series of preferred stock that will be issued to the seed-round noteholders if and when the notes converts—that is, a special sub-series that is designed specifically to protect against artificially-inflated liquidation preference. This is the approach advocated by Ancer. To extend the earlier example, instead of issuing 500,000 shares of Series A to [seed-round] noteholders, issue them 500,000 shares of Series A-2. Series A-2 would just be a series of stock that is exactly the same as the Series A in all respects…except for the liquidation preference…The Series A would have a per share liquidation preference of $4.00 per share, and the Series A-2 would have $1.00 per share. Problem solved.

 

Stand your ground

Obviously, investors have a strong preference for the upside of this hidden liquidation preference—even if they didn’t know they had this benefit before, it’s hard to ask them to give it up once they understand it. Heck, they took a big risk on you!

But it’s good to remember that it’s a practice that’s long been frowned on by VCs for being egregiously greedy and messing up incentives. Early investors are supposed to be appropriately rewarded for their risk by the conversion discount and valuation cap.

When you’re a new entrepreneur struggling to secure funding, it’s easy to let what seems like a minor detail slide—we see it all the time! But those details can literally cost you millions of dollars later on, so it pays to get a good lawyer on your side before you start the process and make sure you ask about this so the appropriate verbiage is in your documents.