3432 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

July 23, 2020

Full Speed Ahead with 500 Startups LatAm’s Batch 12

Recent

Entrepreneurial Women Dish Out Their Very Best Negotiation Hacks

This is a guest post. Negotiating can be a nerve-wracking process. Whether it’s with a future or current employee, potential client, or new partnership, approaching a situation that involves ask...

In Venture Capital, Not All Stages Are Created Equal

The next 100 years of the world’s economy is going to be built off companies just getting started today, and venture capital will play a central role in helping to bring them to life. But while man...

Crypcentra Is Helping Institutional Investors Navigate the World of Crypto

The crypto asset boom of 2017 was powered by retail investors, but now institutional players appear to be coming around to the momentous opportunities offered by digital currencies. A rising number...

Revisiting Our Post-COVID-19 Framework as Parts of the World Reopen

A year ago, we published our post-COVID-19 framework outlining which industries we believed the pandemic would impact and whether the impact would be short-lived or long term. In the midst of much ...