Why is preferred stock convertible into common stock?

July 13, 2007

Many of the provisions in a typical venture financing are designed with an IPO or an M&A event in mind. For example, piggyback and S-3 registration rights (to be described in a later post) are designed to ensure liquidity for an investor after an IPO. A liquidation preference is designed to dictate the order of payment of proceeds in a merger. It would be difficult for an investment bank to market an IPO of common stock of a company where there still was preferred stock outstanding. Therefore, venture capital preferred stock is designed to convert upon an IPO. In certain states, such as California, amending the articles of incorporation or sale of the company require a majority vote of each class of stock, which means common as a class and preferred as a class. In some cases, the preferred stock may want to convert into common stock in order to outvote the common stock. While there are plenty of examples of preferred stock that have debt-like characteristics and are not convertible to common stock, they are not used in venture financings.