Convertible Preferred Stock: How Preferred Is It? (Part One of Two)

Growth investors, including hedge funds, often leave value on the table when negotiating for investments in convertible preferred stock, which is the equity security of choice for investing in emerging growth companies.  Convertible preferred stock provides growth investors with two benefits.  The first is a feature of preferred stock that distinguishes it from common stock: a liquidation preference that is payable in priority to common stock if the company is sold or liquidates.  The second benefit of convertible preferred stock is what distinguishes it from straight preferred: the right to convert the investment into common stock.  This is a valuable right if the company does well enough for its common equity value to increase significantly.  In theory, these twin attributes of convertible preferred stock – enabling the investor to reduce the risk of loss and participate in upside appreciation – make convertible preferred a uniquely attractive investment tool.  Unfortunately, though, that attractiveness can be diminished by defects or gaps in the security’s documentation.  In particular, three value-sabotaging flaws – identified and discussed in this article – regularly appear in supposedly “standard” convertible preferred terms.  These flaws are of particular concern to late round investors, who often acquire their convertible preferred stock at significantly higher prices than earlier round investors.  Since most convertible preferred financings start off with a term sheet, a prospective investor should have an opportunity to identify any of these risks and propose solutions to them before the specific charter provisions for the series are adopted.  With this in mind, this two-part article series provides a roadmap with respect to such risks and provides recommendations to fully capture the benefits of convertible preferred stock investments through effective negotiation of term sheets.  Specifically, this article series addresses the four main areas of a company’s charter where the potential for value-sabotaging flaws is most acute.

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