Anatomy of a Term Sheet - Conversion

Preferred Shares are typically convertible into Ordinary Shares. It would be very difficult to IPO (particularly in Europe) with a mixture of Ordinary and Preferred Shares in issue. The main purpose of making the Preferred Shares convertible is to ensure that the Preferred Shares automatically convert into Ordinary Shares immediately prior to an IPO. Following conversion, most of the Investor protections and preferential rights will fall away and the share capital structure will be greatly simplified.

In most UK transactions, the conversion ratio for Preferred Shares into Ordinary Shares is set at one-for-one. However, depending on how the anti-dilution protection has been constructed (more on this in another post), a subsequent dilutive issue of shares may adjust the conversion ratio such that one Preferred Share will convert into more than one Ordinary Shares.

Preferred shares are designed to convert into Ordinary Shares in the following three scenarios:

(i) firstly, a Preferred Shareholder can request that his Preferred Shares convert (“Voluntary Conversion”). This usually occurs when there is a non-participating liquidation preference or capped participating liquidation preference; or

(ii) secondly, a certain percentage of the holders of the Preferred Shares (an "Investor Majority") can force all of the other Preferred Shares (either on a class-by-class basis or all of the Preferred Shares taken together as a single class) to convert (“Forced Conversion”). Whilst Forced Conversion does not affect the Company directly, the Company should be mindful that the threshold is achievable and that the Company is not held to ransom by a minority shareholder at a later date (Investors too will be mindful of this). Forced Conversion usually occurs when the Investors are looking to:

(A) maximise their returns on a sale of the company (i.e. in the situation where a company has multiple classes of preferred shares and it may be more beneficial for one class of shares to convert into Ordinary Shares to the detriment of the other classes of shares; or

(B) collapse the liquidation preference structure or simplify the cap table (conversion in this scenario usually occurs in extreme down-round situations or upon a recapitalisation of the company); or

(iii) thirdly, upon completion of a public offering meeting specified criteria (“Automatic Conversion”). The criteria usually relates to the amount to be raised in the IPO and the price per share. The amount raised is generally set high enough (such as £25 million or more) in order to ensure that the IPO is (i) a legitimate IPO and (ii) to ensure that the offering creates the “float” (i.e., shares available for trading in the hands of public investors) necessary to provide market liquidity following the public offering . The price per share criteria is typically set as a multiple (ie three times or five times) of the per share investment price. If these criteria are not met, then a company would need to rely upon an Investor Majority to convert.

The Anatomy of a Term Sheet series can be found in full here