Reading: Division of Returns

As we have discussed in the introduction to this chapter, the preceding deal structures focus on exit through "Liquidation Event," which is the for of exit for the overwhelming majority of all deal.

Only few companies ever go public by listing their shares on a stock exchange. Still, most term sheets have a provision in there that defines how the proceeds shall be allocated between the VC and the entrepreneur in the case of an IPO (however unlikely that is).

As it turns out, the corresponding provision is very straightforward: Usually, preferred shares will be converted automatically into common stock in the case of a public offering (or a firm commitment).  The corresponding paragraph in the term sheet is:

Mandatory Conversion (Automatic Conversion):

Each share of Series A Preferred will automatically be converted into Common Stock at the then applicable conversion rate in the event of the closing of a [firm commitment] underwritten public offering with a price of [___] times the Original Purchase Price (subject to adjustments for stock dividends, splits, combinations and similar events) and [net/gross] proceeds to the Company of not less than $[_______] (a “Qualified IPO”), or (ii) upon the written consent of the holders of [__]% of the Series A Preferred.

In an IPO, the valuation of the firm is usually many times higher than the original capital contribution. With a mandatory conversion, the VC can make sure that he participates in such a lucky event. In fact, to make sure that the IPO is indeed a "lucky" event, the VC would typically insist on a minimum value of the IPO (both in terms of offering price as well as overall deal value) to trigger mandatory conversions. IPOs that meet these conditions are called "Qualified IPOs."

Note that the definition of what constitutes a "Qualified IPO" and thereby triggers automatic conversions is an important negotiation point. In particular, entrepreneurs should keep the following in mind:

• Entrepreneurs generally favor a lower threshold of the automatic conversion, as this gives them more flexibility in the IPO negotiations. The reason is that few if any firms ever go public with multiple classes of shares, especially preferred shares, outstanding. Therefore, in order to IPO, all preferred shareholders usually have to convert. The lower the threshold of a qualified IPO, the easier it will be to achieve full conversion.
• For firms with multiple classes of preferred securities outstanding, it is crucial that all classes of preferred securities have the same conversion terms. Otherwise, the series with the highest threshold of a qualified IPO will receive an effective veto right on the offering. Such a right can be (mis)used to extract more favorable terms, at the expense of the other shareholders.