Definition of convertible preferred equity

Venture capitalists (VC) frequently use convertible equity to invest in startups.  Convertible preferred equity blends features of debt and equity into a single security.  Typically, the initial investment is structured as a debt claim, earning interest that accrues unpaid by the company.

At the discretion of the venture capitalist, the debt can be converted into equity at a conversion price that is determined at the time the investment is made.

The venture capitalist’s investment is initially structured like a loan to the company – like a loan, the investment accrues interest that the venture capitalist earns.  But unlike most loans, the venture capitalist has the right, but not the obligation, to convert their loan into equity in the company.

The conversion price of the convertible preferred equity indicates how many shares of equity the venture capitalist receives in exchange for their loan.  For example, a $10m convertible preferred equity security that converts to common equity at $2/share would convert to 5 million shares of common equity if the venture capitalist chose to convert the security to common equity.

To see why the VC might wish to exercise their conversion rights, consider the difference between debt and equity.  In our example, if the company is worth $100m, and it will have 10 million shares outstanding after the conversion to common equity, then each share is worth $10 as common equity after the VC converts.  The terms of their initial agreement allow them to convert their loan at a price of $2 per share, meaning that they can capture $8/share of company value by exercising their conversion right.

The debt-like features of the security offer protection to the venture capitalist in the event that the startup performs poorly, while the ability to convert the security to common equity means that the venture capitalist will share proportionately in the success of the company if it is acquired or becomes publicly traded.

Example
Unlike convertible notes, convertible preferred equity securities place an explicit valuation on the company being funded at the time the investment is made.  This occurs through the conversion price.   

For example, if a convertible preferred security offers 1,000,000 shares for a $5,000,000 investment, and each share of the convertible security converts into five shares of common equity, then the act of converting the security to common equity implies that the VC will have paid 1 dollar per share of common equity. [1]

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