So You Think You Own Preferred Stock?

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.