When the note converts, it converts into a combination of preferred and common stock. The preferred stock converts at the same terms as the leading investor and the sweetener, which is coming from either the cap or the 15% discount is coming from common stock.
It’s a founder friendly provision and a nuanced item we put in. If this point becomes an issue with investors, give on it, and don’t make it a deal breaker to close the round. You can just have it all convert into preferred. This is not a pro-investor provision. The reason it’s put in is preferred stock usually has a liquidation preference and what that means is if I give you $1M in preferred stock and the company exits for just $1M, the preferred investor gets all the money. The first money out goes to the investors and that’s called a liquidation preference. It’s intended to prevent situation where investors only get the portion they put into the company, instead of the return (ie. If the investor puts in $1M for 25% of the company, then the founder sold the company for $1M cash and they didn’t have the liquidation preference, they would only get $250K). So you create preferred shares so that it gets paid out before the common. When the note converts, what the note deserves is the amount of principle that the investor put in. If an investor puts in $1M in the form of a note, and then it converts into preferred shares the liquidation preferences that the investor should get back should just be $1M because that’s what they put in. However, because they invested before the round there are sweeteners you add to the note. The sweeteners are usually a discount on the cap. The discount means that because the investor invested early they are getting 20% more equity effectively or the cap is saying that if the round comes in at a very high valuation then the investor gets a discount via the cap. What the sweeteners says right now is that the investor gets more shares in the form of common stock but it doesn’t get the liquidation preferences associated with those sweeteners because the investor didn’t put in more money. Let’s say the investor put in $1M and it has a cap at $6M, but the round happens at $12M, so the investor gets $2M worth of equity in that round even though they only put in $1M. What the note says is that the investor gets $1M of equity in the form of preferred and the number of common shares that are equivalent to $1M divided by the preferred share price. The total equity they are getting is equivalent of buying 2x the preferred shares for the same price, but the shares that are coming in beyond the capital they put in are coming in the form of common shares, not preferred. The reason we do this is because it protects you as the founder. If you’re in an acquihire situation these small details can matter and ultimately what’s fair is that the investor gets paid back what they put in. They shouldn’t get paid back more than their cash in if the company isn’t paying anything out to the founders.
This is not traditional. Investors are not used to seeing that. We throw that in there because it’s meant to help out the founders and from there negotiate the difference. If an investor is pushing back on this though, I would not let this prevent you from getting the investor check. This would only come into play in when you get acquired and you can renegotiate those at the point of acquisition.
This is how you can argue it with an investor, you can say that if you have it convert to preferred you would effectively have a multiple on your liquidation preferences and we don’t want to set that precedent for future rounds or other investors that invest bigger checks, you don’t want them to ask for a liquidation preference multiple, because they’re getting that.