2 min read

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.

Guest Author

Recent news & articles

See all articles →
Salesforce’s Paula Goldman Talks Ethical Tech for Startups

Salesforce’s Paula Goldman Talks Ethical Tech for Startups

Ethical tech isn’t just a concern for Silicon Valley giants, early stage companies should be focused on it too.
Read more →
Top 19 Insights on Startup Fundraising in a Remote Environment
Fundraising
15 min read

Top 19 Insights on Startup Fundraising in a Remote Environment

The following post is a sponsored guest post by Figure Equity Solutions. All views and opinions represented in this post are the views and opinions of Figure Equity Solutions and do not represent those of 500 Global or any of its staff or affiliates.
Read more →
Putting the Silicon Back in Silicon Valley
materials
5 min read

Putting the Silicon Back in Silicon Valley

The global supply chain disruption reminds us that much of the economy is built on physical goods. So, why is it that software companies get most of the technology industry’s attention?
Read more →
Viewabo Aims to Improve Customer Service With Live Streaming Video Tools

Viewabo Aims to Improve Customer Service With Live Streaming Video Tools

Video streaming can give companies the ability to identify and resolve issues quickly and efficiently, especially when dealing with a complex product.
Read more →