In the past few years promissory notes and SAFEs have become an increasingly popular way to fund early-stage companies. Fenwick completes hundreds of these types of financings for its clients each year and we recently released our second annual report on convertible note terms (Convertible Debt Terms – Survey of Market Trends 2019). It is important for both founders and investors to understand how the economics of these convertible instruments work. This brief article focuses on an important and often overlooked technical component of these securities—one that could have surprisingly outsized economic consequences. It is something that we call “liquidation preference overhang,” and “shadow preferred stock” is the answer.
A Sample Fact Pattern
Meet our early-stage investor, let’s call her Marianne. She invests in a SAFE or a Note in an early financing round of a company. Marianne negotiates a deal with the company that gives her a valuation cap of $5 million. A year after Marianne invests, the company finds an institutional investor, ABC Ventures, and sells preferred stock to them for $1.00 per share, which, suppose for purposes of our example, equates to a $10 million pre-money valuation. Marianne’s instrument converts at the negotiated valuation cap and she winds up “paying” $0.50 per share (since her valuation cap is exactly half of the valuation in the ABC Venture deal). Both Marianne and ABC Ventures receive preferred stock. But should they get the exact same series of preferred stock even though they “paid” different prices for it?
Suppose that ABC Ventures and Marianne received the exact same type of preferred stock — let’s call it Series A. Five years after the ABC Ventures deal, the company sells in a lackluster exit and the holders of Series A preferred stock are going to be paid their liquidation preference instead of converting to common stock. Let’s pause here to clarify that the scenario we are suggesting is one in which the preferred stock is NOT paid on an as-converted-to-common stock basis, in other words, a downside scenario. Suppose Marianne has 10 shares of Series A and ABC Ventures also has 10 shares of Series A. The bankers and lawyers begin calculating how much money is going to be returned to Marianne and ABC Ventures and look at what is called the “original issue price” of the Series A preferred stock in the company’s charter. They see that it is $1.00 — because that is the price per share that ABC Ventures paid for its Series A preferred stock — in order to calculate the amount the holders of Series A will be paid in the exit event. So, the result is that ABC Ventures and Marianne each receive $10.00. But Marianne only paid $0.50 per share and she is being paid out as if she purchased Series A at $1.00 per share. Marianne makes a profit while ABC Ventures breaks even!
Now consider a scenario where the numbers are much larger, in the millions. If there are many investors in the company like Marianne, then the amount of money going to be paid to such preferred holders will be much more than what they had invested. This is called a “liquidation preference overhang.”
Shadow Preferred Stock
Enter “shadow preferred stock” to solve the problem of the liquidation preference overhang. The solution is that Marianne (and other Note or SAFE holders) is issued a sub-series of preferred stock called Series A-1. The Series A-1 has all the same rights and preferences as the Series A — Marianne and ABC Ventures vote together on everything that comes up for a preferred vote and are pari passu in the event of a sale. The only difference is the original issue price — Marianne’s original issue price is the price she paid, $0.50, (i.e., the price at which her instrument converted), and ABC Ventures’ is the price it paid, $1.00. The Series A-1 is known as shadow preferred stock. If there is shadow preferred stock in the capital structure, when the bankers and lawyers calculate how much ABC Ventures and Marianne each will be paid in the sale, they will look to the charter to find the original issue price of each series and the answer will be the amount of money each of them invested rather than ABC Ventures breaking even and Marianne making a profit.
Shadow preferred stock is widely accepted, though it is not a universal rule. Standard SAFEs typically have shadow preferred built in to how they will convert, but not every convertible note does. When raising funds through these instruments, and during preferred stock financings, you should keep shadow preferred stock in mind and think about whether it may be needed. Further, if your notes do not contain a concept of shadow preferred, it may be worth determining how to amend them to add it.