Case Study: The Common and Non-convertible Preferred Structure (Part 2/3)

Alex Wilmerding, Boston Capital Ventures

This is the second of a three part series on structuring private equity and venture capital transactions. VC Experts enables practitioners all over the world to implement best practices through our premium content sections, see specifically the legal forms sections... contributed by experts from the best professional firms in the world.

With these two structures in mind, let's examine a third structure: straight common and straight, non-convertible, redeemable preferred. The explanation that follows and the analysis of the impact of this structure on management have been prepared with the assistance of Tom Claflin of Claflin Capital Management in Boston. Claflin Capital Management has managed some nine funds and, like other venture firms, has used this structure to partner successfully with portfolio companies in a majority of the deals the firm has financed. The common/non-convertible preferred structure is used in a minority of venture deals; however, it strives to align investors and management in a way that is different from how a convertible preferred typically acts.

The common/non-convertible preferred structure requires these two securities to be sold as a unit. In this structure the overall values are the same. If we assume the same example as cited above, in which a model company receives a pre-money valuation of $3 million and seeks to raise $2 million, the investors will, with the common/non-convertible preferred structure, also end up owning 40 percent of the company with their $2 million purchase. However, the investment is divided into two parts. Ninety percent of the investment, or $1.8 million, will purchase a non-convertible redeemable preferred, and 10 percent, or $200,000, will purchase 40 percent of the company's common stock. The 90/10 split is completely arbitrary; an 80/20 split has also been used with success. The ratio may change in later rounds.

While there is an implied overall post-financing value of $5 million based on $2 million of capital exchanged for 40 percent of the equity, this structure brings about a lower pre-money valuation while maintaining management's ownership percentage objective. The total value of the company's common stock is now $500,000 because 40 percent of the common was purchased for $200,000. When the $1.8 million of preferred is added to the $500,000 of common, the total value of the company becomes $2.3 million. This is the break-even value on the investment. If the company is sold for $2.3 million or more, the investors at least get their investment back. The break-even in this example is less than half of the $5 million valuation for a common stock deal.

In either the straight common stock or the convertible preferred stock structures, the investors would just get their cost back if the company were sold for $5 million. In the common/non-convertible preferred structure, if the company were sold for $5 million, the $1.8 million of preferred would be paid off the top, leaving $3.2 million for the common shareholders. The investors' 40 percent common holdings would be worth $1.28 million, bringing the total to $3.08 million, or a gain of 54 percent, compared to a break-even for either of the other two approaches.

In the case of a sale of the company for $20 million with the common/non-convertible preferred approach, the $1.8 million preferred comes off the top, and the remaining $18.2 million is divided among the shareholders. The investors' share of the common is $7.28 million, bringing their total to $9.08 million. This produces an extra $1.08 million, or a 14 percent better return than either the common or convertible preferred approach. In the traditional convertible preferred approach, the investors would have received $8 million for their effective 40 percent share as convertible preferred shareholders.

On the downside, the common/non-convertible preferred structure also works to the investors' advantage. The investors show a profit all the way down to a value of $2.3 million, where the investment reaches break-even. For example, at a $3 million valuation, $1.8 million of preferred comes off the top, leaving the investors' share of the common at $480,000 (40 percent of $1.2 million = $480,000). Thus, the investors would receive a total of $2.28 million if the company were sold for $3 million. Theoretically, for a value between $2.3 and $2 million, the convertible preferred approach is marginally better. However, at those levels, where management will not receive much from a sale, the preferred shareholders will likely be forced to give up some of their return to make the deal work.

Impact on Management

The common/non-convertible preferred approach is shown to be preferable from the investors' viewpoint. What is management's viewpoint? In the above example, management's return is potentially reduced as a function of the company's requirement to pay off the $1.8 million of preferred. In the case of a merger, the preferred definitely reduces management's share of the proceeds. If the company is sufficiently successful to pay off the preferred before being acquired, the negative impact to management is negligible. In the case of an IPO, as a practical matter, management's ownership value is not reduced by this structure. In this case the preferred is redeemed out of the offering proceeds and is lost in the noise level of the transaction.

Although the redeemable feature of the common/non-convertible preferred structure is a potential negative for management, there is a positive aspect, since the value of the common is driven down to one-tenth of the nominal value of a common or convertible preferred structure. This makes it somewhat easier to keep prices of the common lower for the benefit of pricing stock options for key management. To the extent that options are important to the management team, this can be a major advantage. Each equity percentage point has an option cost of $5,000 in the common/non-convertible preferred approach. It cost $50,000 for each percentage in the common stock or preferred approach.

Perhaps most importantly, the common/non-convertible preferred structure can benefit management by effecting a comparatively better valuation and less dilution for management. For example, if a common/non-convertible preferred structure is acceptable to investors at a $3 million pre-financing valuation, as in our company model, a convertible preferred might drop down to a $2.5 million pre-financing valuation and a common stock deal at a $1.5 million pre-financing valuation. The relative valuations of these three alternative structures should settle out where investors are indifferent as to which they would choose. The overall impact to the management as shareholders depends upon the ultimate exit value for the company.

Alignment of the Interests of Stakeholders

Perhaps the most obvious and strikingly important advantage to both management and investors of the common/non-convertible preferred structure is the clear alignment of interests the structure effects. Under such a structure, all participants hold common stock in the company. While the non-convertible preferred portion of an investor's holding is senior to common, and therefore likely to protect a substantial majority of the preferred investor's investment (90 percent in the above example), the remaining investment represents the majority of the investors' actual ownership in the company. As a result, the investor is, at the same time, keenly aware of the common goal of maximizing the value of common stock.

Alignment is further enforced by the simple fact that investors in the common/non-convertible preferred approach have paid one-tenth the price for their stock that would have been paid in a straight common stock structure. Consequently, they have a much higher probability of achieving a profit in their common stock investment sooner than in either of the other alternative approaches.

That the common/non-convertible preferred investors also hold non-convertible preferred has the subtle effect of motivating the non-convertible preferred to be more supportive when times get tough, as well as in the event of a follow-on financing.

When the situation becomes difficult, the preferred is more likely to be sacrificed to protect the investors' equity interest. This is a subtle, but significant, difference between the convertible preferred and the common/non-convertible preferred structures.

In the event of a follow-on financing, the common/non-convertible preferred stockholder is also likely to be more supportive of what might otherwise be a less attractive valuation to the pure convertible-preferred shareholder when the company is having considerable difficulty raising new capital. Consider our earlier example of a company that raised $2 million at a $3 million pre-money valuation. In this example, the original shareholders, in effect, hold 60 percent of the value in the company; the value of the company attributable to new investors represents 40 percent. For the purposes of this example, let's assume that were the financing in the form of a straight convertible security, 32,000 shares were issued at $62.50 to generate $2 million. If $2 million had been raised in the form of a bundle of common/non-convertible preferred securities, let's assume that 10 percent of the round, or $200,000, was issued in the form of 32,000 shares of common stock at $6.25, and 90 percent of the round, or $1.8 million, was issued in the form of 32,000 non-convertible preferred shares at $56.25.

Clearly, a follow-on investment in which a venture group of new investors proposes a new convertible preferred investment at $50 per share will create a different economic result, depending on whether the previous round had been in the form of convertible preferred stock or a combination of non-convertible preferred/common. Were the round in straight convertible preferred stock, the investor whose prior investment had been invested at $62.50 is forced to write-down his investment. The 32,000 shares valued at $62.50 per share need, in effect, to be re-priced on the books of the investor at $50.00. In either scenario, the new imputed value for the company is $4 million (80,000 shares at $50). A $2 million initial investment in convertible preferred would therefore need to be re-priced at $1.6 million on the books of the convertible preferred investor.

In contrast, the investors with common/non-convertible preferred securities would actually have little trouble with such an investment layered on top of their initial investment. Because the non-convertible preferred is non-convertible, its value must, in effect, be subtracted from the imputed value of the company before determining the value of the common. The non-convertible preferred/common investor actually would be able to justify a write-up of their overall investment by 34 percent, assuming at an imputed pre-financing value of $4 million. (80,000 shares x $50 = $4 million, less $1.8 million preferred, leaves $2.2 million for the common shareholders. 40 percent of $2.2 million = $880,000, + the $1.8 million preferred = $2.68 million, which, divided by the $2 million cost, = a 34 percent gain.)

Impact of Common and Non-convertible Preferred on Term Sheet Structure

Naturally the common/non-convertible preferred structure requires that the term sheet agreed to between investors and the company reflect a structure that is modified slightly as compared to the "standard" terms one would expect in a term sheet that involves conventional convertible preferred.

The nature of the common/non-convertible preferred structure contemplated in the financing will require a distinct form of language and structure for the term sheet that outlines such a financing. The distinct structure contemplated will first be outlined in the "New Securities Offered" section of the term sheet. In this section both non-convertible preferred and common shares to be purchased by the new investor need to be stipulated. The term sheet will also require significantly different language in the section "Rights, Preferences and Privileges of the Non-Convertible Preferred." In this section, the "Dividends" language will not necessarily contemplate dividends with respect to the non-convertible preferred stock. While a dividend may accrue, the non-convertible/common structure typically will assume that if a future financing or liquidity event does not transpire (eliminating buy-out of the non-convertible preferred), the non-convertible preferred will be bought out in full from company earnings during a stipulated time period. This will be clearly articulated in the "Liquidation" and "Redemption" clauses. Consequently, no "Conversion and Automatic Conversion" language will be required with respect to the non-convertible preferred, as the security is, by definition, non-convertible. "Dilution" clause language will also not contemplate dilution of the non-convertible preferred. Its value will, in effect, act like a debt instrument and not be subject to dilution. While the non-convertible preferred will require "Voting Rights," as well as "Protective Provisions" and "Special Board Approval Items" language, "Registration Rights" language will not pertain to the non-convertible preferred, only to the common.

Reprint permission from and originally published in Deal Terms, Aspatore Books, All Rights Reserved.