So You Think You Own Preferred Stock?

Prior to the dot-com meltdown, that event was (and only was) the imminence of an initial public offering. The public markets do not like complex capital structures; and, since the IPO is almost always an accretive rather than a dilutive event, the preferred shareholders are happy to convert.

The provision now, however, routinely reads that there are two events compelling all holders to convert to common: the first being the IPO liquidity event and the second being the vote of the majority of the shares of the class (not Series by Series). It is easy to skip over the latter provision, and many professionals have done so, on the grounds that it is “boilerplate.” As I put it to my various audiences, there is no such thing as “boilerplate.” Every phrase in any binding legal document potentially has significant meaning.

What that phrase can mean in this context is illustrated by the following hypothetical: The lead VC in the Series A, B and C rounds is Gorilla LP, the general partner of which is Gorilla LLC, acting in concert with a couple of VCs with which Gorilla is accustomed to syndicating investments. The lead group owns over fifty percent of each of the Series A, B and C. The minority includes a variety of investors, perhaps an angel or two, plus an individual who sold her company to the current issuer in exchange for, say, a minority interest in the Series B round. All of the minority investors in the A, B and C believed that they owned a convertible preferred stock, perhaps even a participating preferred with a juicy valuation preference … three x perhaps. Had the minority holders been represented, however, by me or, say, Carl Kaplan at Fulbright & Jaworski, they would have been informed that, in Kaplan's phrase (and Kaplan is the ultimate cynic, based on his long experience in this sector), “The best you own is common stock.” And his, and to a lesser extent my, reasoning is as follows:

Say the company needs more money; the anticipated exit event, the IPO, has been indefinitely postponed. Otherwise things are on track, but the need for cash is severe.

Gorilla is ready to play in the round but, out of concern for fiduciary duty responsibilities (which I and others have talked about ad infinitum), Gorilla invites an unaffiliated VC, Chimpanzee, to come in and price the D round. Chimpanzee sees an opportunity and says: “We will play but i) only if the price is close to a 'burn out' price, diluting the incumbent shareholders significantly, and ii) if and only if the A, B and C preference and special rights are out of the way.” The company, as is customary in these instances, invites all shareholders to play in the D round; but none of the common and only a few of the A, B and C, other than Gorilla et al., have the resources or the inclination. Gorilla licks its wounds, calculating that it can still retain a significant percentage of the company by playing in the down round, where: the liquidation preference is pegged at 4x participating preferred and includes 100% warrants; the equivalent of a PIK dividend, etc. So Gorilla and its confederates convert the A, B and C into what is now deeply underwater common stock. If the minority complains, the answer is, first, you signed up for a specific security and are presumed to have read the provision which gave the majority the power to compel conversion without limit as to circumstances. Secondly, on the fiduciary duty issue, the round has been independently priced in an arm's length negotiation with an unaffiliated third party, Chimpanzee. That fact, plus the fact that you all were given a level chance to play in a Series D round, should (maybe) rebut the fiduciary duty issue if the company pulls a comeback.

The moral of the story is that, if you want a veto right over compulsory conversion, then specify a Series vote and set the bar high enough so that you (or perhaps you and one or two colleagues) can block the transaction and hold out for a better deal.

You cannot count on common stockholders protection. The common stock majority is typically made up of the founder and current management, all of whom are likely to be key to the future success of the company and, therefore, can count on being made whole through a generous repricing of the stock options, plus additional grants. You may have assumed that Gorilla LLC would never do anything as self destructive as giving up the A, B and C liquidation preference. You fail to take into account, however, the fact that, by participating in a wash out Series D round, and cleaning up the capital structure in the bargain, Gorilla has every incentive to relegate the rest of the preferred holders to the common stock dust bin.

Parenthetically, there is an interesting side bar in these proceedings: Some companies are saddled with multiple series of preferred; and some of the early Series (say, the A holders in our hypothetical) own a security which does not contain in the then existing certificate, a provision for automatic conversion at the behest of the majority. Maybe the Series A was issued at a time prior to all of us thinking about these issues. If, however, the certificate of incorporation has been amended, after the Series A round is closed by a vote of the majority of the entire Class (the Series A, B and C being counted as a single Class), to provide that a majority of the Class may compel conversion, and despite the fact that the amendment to the certificate occurs after the issuance of the Series A (which certificate was silent on the question and, therefore, conferred no such explicit power on the majority of the class), counsel read Section 242(b)(2) of the Del. G.C.L. to provide that Series A is bound by the majority vote of the Class. The reasoning is that the amendment, which clearly alters “the powers, preferences or special rights of one or more series of any class so as to effect them adversely,” is a valid change in the rights of the Series A because the amendment “affect[s] the entire class,” including each Series.

Of course, it is always open to our truculent disgruntled minority holder to argue the fundamental unfairness of the transaction, claiming the authorizing amendment is a violation of the insiders' fiduciary duty (“fiduciary duty” being an equitable doctrine of imprecise meaning – a phrase I have suggested is synonymous, when appearing a court's opinion, with “recovery for the plaintiff.”) Assuming, accordingly, that even though the votes in favor of converting the prior Series of preferred are based on the letter of the Delaware statute, some will argue the sponsors should pay attention to basic fairness principles.

And, of course, there are a variety of time tested and judicially honored methods for the insiders to follow in order to stake a claim to the 'business judgment rule' protection by following fair “procedures” … disinterested director committees, independent counsel thereto and other steps set out in the so-called “road map” cases in Delaware. There are a number of possible prophylactic initiatives. (It is critical for the procedures to be adjudicated fair; if a test is “substantive fairness,” focusing on the price, then the complaint cannot be disposed of on preliminary motions and, in effect, the plaintiff's counsel will have won the right to a hefty fee.) One such method frequently encountered in today's environment deserves special mention. That is, the board affords the earlier preferred holders a triple opportunity: to play for fresh cash in the Series D round; to stand on the sidelines and see their shares converted to common; and/or to exchange preferred shares, using the liquidation preference/conversion price as currency, for Series D shares. In the latter case, the minority preferred holders can convert into the Series D without coming up with any fresh consideration. That tender is, of course, economically advantageous to Gorilla to the extent Gorilla owns A, B and C. Automatic conversion is, in effect, a form of play or pay. However, the triple offer (always subject to the 'facts and circumstances' qualification) could be effective in neutralizing the fiduciary duty claim of our truculent minority shareholder, at least as far as the prior preferred is concerned.

It is no secret that the bulk of today's activity in the private equity sector is taken up with late rounds of financing. Typically, the VCs (ie, private equity funds, including but not limited to funds which are the incumbent in a particular company's series of preferred shares) negotiate the terms of, let's call it, the Series D round ' a so-called “follow on” round. The D Round succeeds, in point of time, the initial issuance to the following investors: common stock to the founders, friends and family and sometimes angels, followed by Series A, B and C convertible preferred shares, to the professional investors.

As VCs in the D round survey the balance sheet and capital structure, they note it is sufficiently cluttered that the company, unless it cleans up its capital structure, may be unfinanceable. And, while the majority of the holders of the A, B and C Series may be amenable to a new round of financing, the vote in favor of the term sheet suggested by the investors in the Series D round (often highly dilutive) may be less than one hundred percent. There is often an intractable, truculent holdout ' someone or some institution who or which, for one reason or another, has entirely lost confidence in the company and its management, or is otherwise disaffected. Some of the holdouts may be impervious to the argument that, absent new financing, the company will fail. “Let it fail,” may be their response. Or, alternatively, “pay me extra baksheesh to persuade me to give up my blocking position.”

I and others have written extensively on this subject (See www.vcexperts.com; Buzz of the Week, “The Overhang Problem, “1/7/2001, Book 11 on Down Rounds, plus Section 5.3 Fiduciary Duties of Controlling Shareholders in Down Rounds, of The Encyclopedia of Private Equity and Venture Capital, which deal with the subject of 'down rounds' generally.) The problem, in short, did not arise the day before yesterday; it has been around for years, with heightened interest since the dot-com meltdown a couple of years ago. And, the professionals in this business have naturally reacted to the issue in structuring private equity financings. Thus, the typical certificate of incorporation or designation establishing the terms of various series of preferred stock (and, for reasons described below, it almost always is a separate series versus a separate class), reads conventionally, until one gets to the automatic conversion provision ' that section of the certificate which compels the entire series (say the Series A, B and C) to convert into common stock upon the occurrence of certain events.

Prior to the dot-com meltdown, that event was (and only was) the imminence of an initial public offering. The public markets do not like complex capital structures; and, since the IPO is almost always an accretive rather than a dilutive event, the preferred shareholders are happy to convert.

The provision now, however, routinely reads that there are two events compelling all holders to convert to common: the first being the IPO liquidity event and the second being the vote of the majority of the shares of the class (not Series by Series). It is easy to skip over the latter provision, and many professionals have done so, on the grounds that it is “boilerplate.” As I put it to my various audiences, there is no such thing as “boilerplate.” Every phrase in any binding legal document potentially has significant meaning.

What that phrase can mean in this context is illustrated by the following hypothetical: The lead VC in the Series A, B and C rounds is Gorilla LP, the general partner of which is Gorilla LLC, acting in concert with a couple of VCs with which Gorilla is accustomed to syndicating investments. The lead group owns over fifty percent of each of the Series A, B and C. The minority includes a variety of investors, perhaps an angel or two, plus an individual who sold her company to the current issuer in exchange for, say, a minority interest in the Series B round. All of the minority investors in the A, B and C believed that they owned a convertible preferred stock, perhaps even a participating preferred with a juicy valuation preference … three x perhaps. Had the minority holders been represented, however, by me or, say, Carl Kaplan at Fulbright & Jaworski, they would have been informed that, in Kaplan's phrase (and Kaplan is the ultimate cynic, based on his long experience in this sector), “The best you own is common stock.” And his, and to a lesser extent my, reasoning is as follows:

Say the company needs more money; the anticipated exit event, the IPO, has been indefinitely postponed. Otherwise things are on track, but the need for cash is severe.

Gorilla is ready to play in the round but, out of concern for fiduciary duty responsibilities (which I and others have talked about ad infinitum), Gorilla invites an unaffiliated VC, Chimpanzee, to come in and price the D round. Chimpanzee sees an opportunity and says: “We will play but i) only if the price is close to a 'burn out' price, diluting the incumbent shareholders significantly, and ii) if and only if the A, B and C preference and special rights are out of the way.” The company, as is customary in these instances, invites all shareholders to play in the D round; but none of the common and only a few of the A, B and C, other than Gorilla et al., have the resources or the inclination. Gorilla licks its wounds, calculating that it can still retain a significant percentage of the company by playing in the down round, where: the liquidation preference is pegged at 4x participating preferred and includes 100% warrants; the equivalent of a PIK dividend, etc. So Gorilla and its confederates convert the A, B and C into what is now deeply underwater common stock. If the minority complains, the answer is, first, you signed up for a specific security and are presumed to have read the provision which gave the majority the power to compel conversion without limit as to circumstances. Secondly, on the fiduciary duty issue, the round has been independently priced in an arm's length negotiation with an unaffiliated third party, Chimpanzee. That fact, plus the fact that you all were given a level chance to play in a Series D round, should (maybe) rebut the fiduciary duty issue if the company pulls a comeback.

The moral of the story is that, if you want a veto right over compulsory conversion, then specify a Series vote and set the bar high enough so that you (or perhaps you and one or two colleagues) can block the transaction and hold out for a better deal.

You cannot count on common stockholders protection. The common stock majority is typically made up of the founder and current management, all of whom are likely to be key to the future success of the company and, therefore, can count on being made whole through a generous repricing of the stock options, plus additional grants. You may have assumed that Gorilla LLC would never do anything as self destructive as giving up the A, B and C liquidation preference. You fail to take into account, however, the fact that, by participating in a wash out Series D round, and cleaning up the capital structure in the bargain, Gorilla has every incentive to relegate the rest of the preferred holders to the common stock dust bin.

Parenthetically, there is an interesting side bar in these proceedings: Some companies are saddled with multiple series of preferred; and some of the early Series (say, the A holders in our hypothetical) own a security which does not contain in the then existing certificate, a provision for automatic conversion at the behest of the majority. Maybe the Series A was issued at a time prior to all of us thinking about these issues. If, however, the certificate of incorporation has been amended, after the Series A round is closed by a vote of the majority of the entire Class (the Series A, B and C being counted as a single Class), to provide that a majority of the Class may compel conversion, and despite the fact that the amendment to the certificate occurs after the issuance of the Series A (which certificate was silent on the question and, therefore, conferred no such explicit power on the majority of the class), counsel read Section 242(b)(2) of the Del. G.C.L. to provide that Series A is bound by the majority vote of the Class. The reasoning is that the amendment, which clearly alters “the powers, preferences or special rights of one or more series of any class so as to effect them adversely,” is a valid change in the rights of the Series A because the amendment “affect[s] the entire class,” including each Series.

Of course, it is always open to our truculent disgruntled minority holder to argue the fundamental unfairness of the transaction, claiming the authorizing amendment is a violation of the insiders' fiduciary duty (“fiduciary duty” being an equitable doctrine of imprecise meaning – a phrase I have suggested is synonymous, when appearing a court's opinion, with “recovery for the plaintiff.”) Assuming, accordingly, that even though the votes in favor of converting the prior Series of preferred are based on the letter of the Delaware statute, some will argue the sponsors should pay attention to basic fairness principles.

And, of course, there are a variety of time tested and judicially honored methods for the insiders to follow in order to stake a claim to the 'business judgment rule' protection by following fair “procedures” … disinterested director committees, independent counsel thereto and other steps set out in the so-called “road map” cases in Delaware. There are a number of possible prophylactic initiatives. (It is critical for the procedures to be adjudicated fair; if a test is “substantive fairness,” focusing on the price, then the complaint cannot be disposed of on preliminary motions and, in effect, the plaintiff's counsel will have won the right to a hefty fee.) One such method frequently encountered in today's environment deserves special mention. That is, the board affords the earlier preferred holders a triple opportunity: to play for fresh cash in the Series D round; to stand on the sidelines and see their shares converted to common; and/or to exchange preferred shares, using the liquidation preference/conversion price as currency, for Series D shares. In the latter case, the minority preferred holders can convert into the Series D without coming up with any fresh consideration. That tender is, of course, economically advantageous to Gorilla to the extent Gorilla owns A, B and C. Automatic conversion is, in effect, a form of play or pay. However, the triple offer (always subject to the 'facts and circumstances' qualification) could be effective in neutralizing the fiduciary duty claim of our truculent minority shareholder, at least as far as the prior preferred is concerned.