Conversion rights in venture capital transactions: key considerations

Convertible preference shares create the ability for investors to do this, by allowing a holder to convert their preference share position into ordinary shares, either at a time of their choosing or on the occurrence of specified events. Conversion is usually at a pre-determined price or by reference to an agreed formula, which can vary the price depending on a variety of factors. Understanding how and when conversion can occur and the conversion ratio and price that will be applied is crucial for both investors and founders, as it can have a significant impact on the risk/reward profile for all shareholders. It can also have an impact on the ability of the company to attract further investment. Below, we highlight some of the key considerations in a convertible share structure. 

How and when conversion takes place - trigger events and investor controls

Preference shares are typically convertible into ordinary shares on the occurrence of agreed ‘trigger events’, usually comprising of some, or all of the following:

• at the option of the investor/holder of the preference shares
• at the option of the founders/company
• on a specified date
• on the occurrence of a further fundraising event
• on the occurrence of an exit (being a sale of the company or an IPO)
• on the achievement of specified financial milestones (or on a failure to achieve certain financial milestones) 

Conversion at the option of the investor

In VC transactions, investors will often require the right to convert their preference shares at a time of their choosing, typically exercised when a company is performing well and the investor can maximise returns by holding ordinary shares. This often occurs in anticipation of a further, larger fundraising or exit event, when an investor is happy to give up the downside protection of preference share rights. It can help the attractiveness of the company for future funding to simplify or ‘flatten’ the equity structure in this way.

Conversely, an investor may also seek to convert in circumstances where the business is not performing, usually at a more advantageous conversion price/ratio, and where they wish to influence the direction of the company (given that ordinary shares have voting rights). Conversion in these circumstances would typically allow the investor to dilute other shareholders and therefore be in a position of greater economic and voting control, possibly even taking a majority equity stake and re-setting the share structure in its favour. 

Investors may also seek further flexibility by negotiating a partial rather than a full conversion. This provides investors with the security of retaining a proportion of preference shares in certain circumstances.

Automatic conversion triggers

Investors and founders will also be likely to seek to agree certain automatic trigger events, typically including: on (or immediately prior to) the occurrence of an exit or qualifying fundraising event; on a specified date, if an exit has not been achieved; or, on the achievement of a specified financial milestone. 

In relation to an exit, the conversion itself will usually occur immediately prior to the sale or IPO, ensuring that any preference share protections are maintained until the exit occurs, and the valuation of the exit can be applied to the conversion mechanism. This allows the investor to participate fully alongside the ordinary shareholders.     

In setting out the parameters for automatic conversion on a fundraising or exit, the company and the investor will need to take particular care in relation to the definition of a “qualifying” fundraising or IPO, which will specify the criteria for conversion, such as the minimum amount of proceeds to be raised, a minimum price per share valuation, the identity of acceptable investors, and (in an IPO scenario) the exchange on which the shares are to be listed. Non-qualifying events may be subject to an investor veto, or a conversion price that is more advantageous to the investor.

Price and conversion ratio 

Fundamental to the structure is the conversion price – being the relative valuation of the preference shares to ordinary shares, to be applied at the point of conversion. This impacts the ratio of conversion – being the number of ordinary shares that any holding of preference shares will convert into. 

A conversion may be at a fixed price per share, agreed at the outset of the investment, or by reference to an agreed formula usually specified in the articles of association (Articles). The Articles set the conversion price by reference to factors such as: the financial performance of the company since the issue of the preference shares; the valuation of the company during subsequent funding rounds; the amounts returned to shareholders in the period since the issue of the preference shares; and the proceeds available for distribution on the exit event.

The conversion ratio typically adjusts the number of ordinary shares by reference to the conversion price and will also cater for changes in the capital structure, in order to protect against dilution of the investor’s shares.

Adjustments for anti-dilution 

One of the most important features of preference shares is anti-dilution protection. If a company issues new shares at a price lower than the price initially paid by the investors (a ‘down round’), the conversion ratio may be adjusted to protect the investors from dilution. This adjustment can take various forms, such as a ‘weighted average’ or ‘full ratchet’ mechanism and ensures that investors continue to maintain their pro rata proportion of the company’s equity throughout the life cycle of their investment (or have the option to approve a dilution of their position).

Usually, a founder would have a preference towards a weighted average mechanism, considering this is a weaker form of anti-dilution mechanism. This would adjust the number of additional shares that an investor would receive based on the size and price of the down round relative to the investee’s existing share capital. Under a full ratchet, the investor's original investment is re-priced at the share price of the down round, and the investor receives a bonus issue of new shares to increase its shareholding to what it would have received had its original investment been made at the down round price.

Whilst such provisions may make it easier to secure investor funding by making investments more attractive, from a founder’s perspective, anti-dilution provisions could also lead to significant founder dilution, impacting management and employee shareholder motivation and make it difficult to attract further funding.  

Practical implications 

Preference shares and conversion rights are a key tool in structuring an investment and provide good protections to institutional investors. This allows early-stage or high growth companies to attract significant investors on valuations that would not otherwise be achievable.

For investors, broad and well thought out conversion rights and carefully drafted anti-dilution provisions are essential tools for managing their investment risk and maximising returns.

It is important to note, however, that the financial and structuring implications of including preference shares and conversion rights can be significant and can have a material impact on future fundraising opportunities and valuations. Professional advice, supported by careful negotiation and drafting of the conversion rights is essential.  

Thank you to Jagdeep Lall and Kirsty Wright for the contribution of this article.

DWF has the largest venture and growth capital group in the UK with over 85 lawyers in 10 offices, and supports investors and companies across several sectors including financial services, technology, media and telecommunications, life sciences and healthcare and real estate and infrastructure. If you have queries on any of the issues covered in this article please contact one of our experts.