TL;DR Nutshell: Standard capped convertible notes have a flawed structure in that noteholders often end up, when their notes convert, with substantially more liquidation preference than they actually paid for; which means money taken from founders’ pockets and placed in those of investors, without justification. As companies continue to push their “Series A” rounds further out with various series of capped convertible notes, the problem is growing, and a corrected note conversion structure should become the norm.
The existence of the “liquidation overhang” problem in capped convertible notes is not news. It can be explained with a simple mathematical example:
Assumptions for Hypothetical:
- $500K seed round with notes carrying a $2.5MM valuation cap.
- Series A has a $10MM pre-money valuation, resulting in a per share price for new money of $4.00.
- The Series A has a run-of-the-mill 1x participating liquidation preference. This means that the Series A have a per share liquidation preference of $4.00.
- The $2.5MM valuation cap means the notes convert at $1.00.
Under the above example, the $500K in notes will convert, ignoring interest, into 500,000 shares. $500,000 / $1.00
If the Notes convert directly into the same Series A preferred stock as “new money” investors get (which is what most notes require), their aggregate liquidation preference is $2 million. 500,000 shares * $4.00
So those investors paid $500,000, but they have $2 million in liquidation preference. In other words, they got a 4x participating liquidation preference. The $1.5 million difference is the “liquidation overhang.” Ask me if I think founders/common stockholders care whether they will get an extra $1.5 million in an exit.
If you increase the size of the seed round (which is happening in the market), the overhang gets bigger on a dollar basis. (1MM shares * $4.00) – $1,000,000 = $3 million.
If you increase the gap between the Series A valuation and the seed “cap” valuation (which is also happening in the market), the overhang also gets bigger. A $15 million Series A valuation, with a $6 share price, produces a liquidation overhang of $2.5 million. (500,000 shares * $6.00) – $500,000
So as seed rounds get larger, and Series A rounds are extended further out (with higher valuations), the liquidation overhang grows, and more money is transferred from founders to investors. Historically, convertible notes were called “bridge” notes because they were closed only a few months before a full equity round, offering a small discount to the Series A price. When the price differential is only 10-20%, the overhang is perhaps worth ignoring. But when the Series A valuation is 2-3x+ of the seed valuation, it’s time to pay attention.
The Most Viable Solutions
The two most common solutions to the liquidation overhang are as follows, and both have tradeoffs.
Create the “Discount” with Common Stock – Instead of issuing (in the above example) 500,000 shares of Series A to the noteholders, issue them 125,000 Series A shares, and the remaining 375,000 as common shares. In the end, they still have 500,000 shares, but their liquidation preference is equal to their purchase price. 125,000 * 4 = $500,000.
The downside to this approach is that it can significantly affect the voting of common stock. There is almost always a stock class divide with “common stock” representing founders, executives, employees, and other people performing services, and “preferred stock” being investors. This keeps things simple when calculating approval thresholds for a major transaction – the “common vote” is a very distinct group from the “investor vote.” However, depending on the numbers, it’s very easy with this “common stock solution” to reach a point where a very large chunk of the common stock is in fact investors, reducing the voting power of founders. Not an insurmountable problem, but it is a problem.
Issue Sub-Series of Preferred Stock – This is actually my favored approach. In the above example, instead of issuing 500,000 shares of Series A to the noteholders, issue them 500,000 shares of Series A-2. Series A-2 would just be a series of stock that is exactly the same as the Series A in all respects, including voting, except for the liquidation preference (and basis of anti-dilution and dividend rights, which are related). The Series A would have a per share liquidation preference of $4.00 per share, and the Series A-2 would have $1.00 per share. Problem solved.
The most commonly brought-up downside to this approach is that it creates more complexity in the Company’s deal documents and cap table. While it’s true that you will need to do a bit more work in the company’s deal docs, it does not take that much work to create a Series A and Series A-2, but have them all work together for everything other than liquidation preference. Even if you have multiple valuation caps, doing a Series A, A-2, A-3, etc. is not that hard.
My somewhat cynical view is that this complaint comes mostly from (i) investors who are trying to convince founders that all of this liquidation overhang “stuff” isn’t that big of a deal and not worth addressing (meaning, an extra few million in their pockets isn’t a “big deal”), or (ii) lawyers at overpriced firms who are ALWAYS running over fixed legal budgets, so having to do ANY kind of extra customization to their template docs results in kicking and screaming.
In the exact same way that “why do we need two sets of lawyers? just use ours, and save on legal fees” is complete non-sense designed to screw founders, the “just give everyone Series A shares and keep it simple” position is ridiculous given the economic impact on founders. If you’re being told to pay a few extra thousand in legal to potentially save several million in an exit, the issue is fundamentally an IQ test.