1370 Views

Are there ghosts in your convertible notes?

Guest blogger – Adam Sterling is the executive director of the Berkeley Center for Law, Business and the Economy, co-founder of Startup@BerkeleyLaw, and a former venture capital and startup attorney.

Are you investing in convertible notes or securities? Do you know what a phantom liquidation preference is? Did you know it could cost you hundreds of thousands of dollars? Let’s illustrate how with a simple example…

Sally purchases a convertible note with a valuation cap of $5 million in Tuber Corporation for $100,000. Six months later, Tuber closes its Series A with a pre-money valuation of $10 million, selling new shares at $1/share. Thanks to its valuation cap, Sally’s convertible note converts at $0.50/share and she receives 200,000 shares of Series A stock. Sally’s very happy about this outcome.

Source www.billionbackrecords.com

A year later, Tuber is acquired. Unfortunately, the acquisition price is not enough to trigger a conversion of the preferred stock. Series A holders will just receive their liquidation preference. Assuming the Series A investors negotiated a standard liquidation preference, each Series A holder should receive the “original issue price” of their Series A stock. The question for Sally then becomes, is the “original issue price” of her Series A stock $0.50 share or $1.00 share?

Assuming Sally’s convertible notes were silent on this issue, Sally would most likely be entitled to receive a liquidation preference of $1.00/share in the above example or $200,000 (an outcome that greatly benefits Sally). This benefit to Sally, getting $1.00/share as opposed to $0.50/share (which ends up being worth $100,000), is known as a phantom liquidation preference.

While most investors would prefer to keep this phantom liquidation preference, many companies are drafting convertible notes to avoid it. Their argument is that investors are double-dipping — benefiting from the discount/valuation cap when their security converts and again with the liquidation preference. This argument may be valid, but as an investor you should at least be aware of it. As some investors successfully retain the preference, it could be worthwhile to fight to keep it. 

Understanding nuanced concepts like this can provide investors with a critical edge in the crowded venture capital space. To this end, UC Berkeley will be partnering with 500 Startups at Venture Capital Deal Camp in February to breakdown concepts like this and explore other mechanics of early-stage deal making. Deal Camp also features VIP access to 500’s famous Preview Day and simulated negotiations with real companies. Check it out and consider applying!

Thank you to Adam Sterling for contributing to the 500 blog. For more insights from Adam, follow him on Linkedin or Twitter.

Most Popular

June 09, 2020

Our Framework Post-COVID-19

May 22, 2020

Launch Your Business in Georgia (The Country, not the State)

Recent

Accelerating ESG Adoption in Early Stage Venture Capital

The year 2020 has served up many reminders of the pressing issues facing society, from failures to address systemic discrimination to the impending climate crisis. Moving forward, realizing a more ...

Meet the Startups in 500’s First Fully Virtual Accelerator

At 500 Startups, innovation is a staple of our business model. In March, we announced the revamp of our SF flagship accelerator program to offer year-round enrollment flexibility to meet our founde...

15 Tips to Bringing Teams Closer Even During Tough Times

We are living through one of the largest collective challenges the world has faced, so it’s the perfect time to tap into the experience of these 15 female leaders. They offer tips for bringing team...

500 Startups Bolsters Commitment to MENA’s Startup Ecosystem

500 Startups made its first investment in MENA in 2012. Back then, few U.S. venture investors made their way to the region, but we recognized its potential and after making more than 30 investments...