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Hidden Trap Of Convertible Note and Liquidation Preference Multiples
I came across this very old article by one of the late venture capitalists and it caught my attention. It discusses some of the hidden traps of convertible note and liquidation preference multiple that most of the founders are unaware of.
If you are raising the pre-seed, seed or bridge round a convertible note could be the best option for you! If you want to know more about the convertible note and liquidation preference, read our previous newsletter blogs. Links are below:
Understand Convertible Note Investment Option: Read Here
Decoding Term Sheet - Understanding Liquidation Preference: Read Here
Must read to understand this writeup better.
So the article I stumbled upon was merely a conceptual story. However, I couldn't resist sharing this valuable insight with all of you by providing a simple example. So, let’s deep dive into it to understand the trap that every founder should be aware of!
Consider an example where a founder discovers that their Series A investors are entitled to a 1X Liquidation Preference, while the Convertible Note (CN) investors have a significantly higher 4X Liquidation Preference.
One can only imagine the challenging situation the founder must be facing with certain investors having a 4X Liquidation Preference.
Let’s start with a simple example - consider a founder raising a seed round such that
Seed Round Convertible Note Dynamics:
Principal Amount- $500k
Interest Rate= 10%
Discount- 20%
Valuation Cap= $2.5m
Maturity Years= 2
Convertible Note Principal plus Accrued Interest= $500k*(1+10%)^2= $605k
Now the same founder is raising the Series A round with -
Series A Round Dynamics:
Pre-money Valuation of the company $10m
Share Price= $4
1X Liquidation Preference (not including Participating/ non-participating for the simplicity purpose)
Convertible Note Conversion Dynamics after Series A:
Share Price (Valuation Cap option) = $4*($2.5m/ $10m) = $1
Share Price (Discount option) = $4*(1-20% = $3.2
Convertible Note Investor will choose the Valuation Cap Option
Number of Shares with Convertible Note Investors = $605k/ $1 = 605,000
Current Share Price = $4
Convertible Note Investors Investment Value = 605,000*$4 = $2.42m
Convertible Note Investors Initial investment = $500k
Convertible Note Investors Investment Value after Series A $2.42m
They are getting $2.42m/ $500k = 4.84X return whereas the Series A investors are getting only 1X Liquidation Preference.
This is excellent for the Convertible Note Investors but not good for the Founders.
That’s why a Founder should always keep the liquidation preference multiples in check.
Here Is How:
I Was going through an article written by Mark Suster where he suggested to the Founders what they should include in the agreement. It goes like this:
“If this note converts at a price higher than the cap…your stock [will] be converted such that you will receive no more than a 1x non-participating liquidation preference plus any agreed interest.”
Issue sub-series of preferred stock.
Founders have an alternative approach to safeguard themselves from the impact of multiple liquidation preferences.
They can incorporate a provision in the convertible note that outlines the creation of a distinct sub-series of preferred stock exclusively for the seed-round noteholders upon conversion.
This unique sub-series is specifically designed to counteract artificially inflated liquidation preferences and provide added protection to the founders.
Instead of granting 605,000 shares of Series A to the Seed-round convertible noteholders, allocate them 605,000 shares of a new stock series called Series A-2.
Series A-2 would possess identical characteristics to the original Series A, except for the liquidation preference.
While Series A holds a per-share liquidation preference of $4.00, Series A-2 would have a reduced liquidation preference of $1.00 per share. This resolution effectively resolves the issue at hand.
That’s it for today.
I hope this gives the idea of trap in the convertible note and liquidation preference multiple and the ways to tackle it.
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✍️Written By Sahil | Venture Crew Team