The Hedge Fund Law Report

The definitive source of actionable intelligence on hedge fund law and regulation

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By Topic: Convertible Preferred Stock

  • From Vol. 7 No.1 (Jan. 9, 2014)

    Convertible Preferred Stock: How Preferred Is It? (Part Two of Two)

    Convertible preferred stock investments provide important benefits for hedge funds and other investors including, among other things, a liquidation preference and the right to convert the investment into common stock of the company.  Nonetheless, an investor’s failure to rigorously negotiate a term sheet with respect to a convertible preferred stock investment before the specific charter provisions for the series are adopted can lead to inclusion of benefit-sabotaging terms that enable the company to leak value to the common stock while the convertible preferred remains outstanding; force conversion to occur sooner than the investor might like; and allow the preferred investor’s bargained-for terms to be amended away.  There are four principal areas of a company’s charter where the potential for value leakage, premature conversion or the loss of rights via amendment is most acute.  This is the second article in a two-part series identifying these risks and providing recommendations to assist investors in negotiating convertible preferred term sheets to fully capture the benefits of such investments.  The authors of this series are William Q. Orbe, founding partner of Richards Kibbe & Orbe LLP (RKO); Thao H.V. Do, a partner at RKO; and Catherine Rossouw, an associate at RKO.  See also “Convertible Preferred Stock: How Preferred Is It? (Part One of Two),” The Hedge Fund Law Report, Vol. 6, No. 48 (Dec. 19, 2013).

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  • From Vol. 6 No.48 (Dec. 19, 2013)

    Convertible Preferred Stock: How Preferred Is It? (Part One of Two)

    Growth investors, including hedge funds, often leave value on the table when negotiating for investments in convertible preferred stock, which is the equity security of choice for investing in emerging growth companies.  Convertible preferred stock provides growth investors with two benefits.  The first is a feature of preferred stock that distinguishes it from common stock: a liquidation preference that is payable in priority to common stock if the company is sold or liquidates.  The second benefit of convertible preferred stock is what distinguishes it from straight preferred: the right to convert the investment into common stock.  This is a valuable right if the company does well enough for its common equity value to increase significantly.  In theory, these twin attributes of convertible preferred stock – enabling the investor to reduce the risk of loss and participate in upside appreciation – make convertible preferred a uniquely attractive investment tool.  Unfortunately, though, that attractiveness can be diminished by defects or gaps in the security’s documentation.  In particular, three value-sabotaging flaws – identified and discussed in this article – regularly appear in supposedly “standard” convertible preferred terms.  These flaws are of particular concern to late round investors, who often acquire their convertible preferred stock at significantly higher prices than earlier round investors.  Since most convertible preferred financings start off with a term sheet, a prospective investor should have an opportunity to identify any of these risks and propose solutions to them before the specific charter provisions for the series are adopted.  With this in mind, this two-part article series provides a roadmap with respect to such risks and provides recommendations to fully capture the benefits of convertible preferred stock investments through effective negotiation of term sheets.  Specifically, this article series addresses the four main areas of a company’s charter where the potential for value-sabotaging flaws is most acute.

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