Term Sheets: What are conversion rights?

This week we continue our series on key VC financing deal terms.

This week’s question: What do I need to know about conversion rights?

Our answer: Conversion rights refer to the rights of preferred stockholders to convert their preferred shares into common stock, typically on a 1:1 basis, either voluntarily or automatically under certain conditions. Although seemingly simple in concept, conversion rights underpin numerous key terms and variations that dramatically affect your control and upside at crucial moments in your startup’s journey. For negotiation, aim for balanced terms by (i) ensuring conversion triggers are clearly defined and market standard, (ii) using weighted average anti-dilution protections (see below), and (iii) pushing back on overly aggressive terms such as full-ratchet anti-dilution protection (see below) or high IPO conversion thresholds.

Types of Conversion Rights

Conversion rights fall into two general categories.

1. Optional Conversion Rights: Allows investors to convert at their discretion, usually during a favorable exit even such as an acquisition.

2. Mandatory Conversion Rights: Requires investors to convert preferred stock to convert into common stock upon either a qualified IPO (ie. one meeting minimum valuation and proceeds thresholds) or the vote of a certain threshold of preferred shares. Note that aggressive terms (e.g. an unusually high minimum IPO valuation) may delay an IPO or allow your investors to retain leverage longer than you intended.

Anti-Dilution Protections

A critical concept tied to conversion rights is anti-dilution protection, which protects investors from dilution in down rounds by modifying the conversion ratio from 1:1 to a new ratio.  There are two main methods of anti-dilution protection used:

1. Full-Ratchet: The most investor-favorable protection. In a down round, the conversion price resets to that lower price, giving investors a windfall and significantly diluting founders and existing holders.

2. Weighted Average: A more balanced protection. This method adjusts the conversion price based on a formula that accounts for both price and number of new shares issued, but doesn’t reset to the lower price in a down round. Note that There are two types: (i) Broad-based (more common and founder-favorable) and (ii) Narrow-based (less favorable). Weighted average anti-dilution is considered market standard. Any deviation (especially toward full-ratchet) should be negotiated against.

Why It Matters

Although conversion rights are a standard part of VC financings, you should not view them as a boilerplate set of terms. Instead, they are negotiable elements that can materially affect your dilution, control, and outcomes in an exit event or IPO, so should be carefully considered.