What is upgradeable Series A preferred stock?

September 12, 2008

Occasionally, I see a new provision in a term sheet, which keeps things interesting for me. I’ve decided to call this type of Series A preferred stock “upgradeable” (after recently realizing that there are economy class plane tickets that aren’t upgradeable despite having system-wide upgrade certificates). The term sheet provides:

The Series A Preferred shall also be convertible into any future series of Preferred Stock (the “Future Preferred”) under either of the following circumstances: (a) if such conversion is approved by the Board or (b) if such conversion is in connection with a future Preferred Stock equity financing in which the Company’s fully diluted pre-money valuation is greater than the Company’s fully diluted post-money valuation immediately following the Series A Financing contemplated by this term sheet (a “Future Financing”), in either case, on a one-for-one basis (subject to anti-dilution adjustment) at the option of the holder; provided however, if such conversion is in connection with a Future Financing, that the holder may convert into shares of Future Preferred only in the event that all of such shares of Future Preferred received by the holder upon conversion are sold to an Approved Investor (as defined below) no later than 90 days following the first closing of the Future Financing at a price per share no lower than the price per share at which the Company sells shares of such Future Preferred in the Future Financing and, provided further, that such Approved Investor is not an affiliate, family member, or related party of the holder. For the purposes of the preceding sentence, “Approved Investor” means (1) a bona fide institutional investor, or (2) any investor who has invested at least $1 million in the Company. For the avoidance of doubt, any conversion into Future Preferred in connection with a Future Financing that does not result in a sale of such Future Preferred to an Approved Investor on the terms set forth above shall be void, and such Future Preferred shares shall be deemed re-converted into Series A Preferred Stock automatically and without further action on the part of the holder.

Basically, this is a variation on Series FF stock that I have previously written about.  Instead of the stock being issued to founders, the “upgradeable” Series A stock is issued to early investors.  If the early investors want to sell their stock to investors in a later financing round, the Series A stock is convertible into the later round of preferred stock.  This is helpful for early investors who may want liquidity prior to the sale of the company or an IPO.  Assuming the Series B is sold at $2 per share and the Series A was sold at $1 per share, the Series B investor typically would not want to pay $2 per share for a Series A stock with price-based rights (i.e. liquidation preference) at $1 per share.  Of course, allowing an exchange of stock with a lower liquidation preference to a stock with a higher (and potentially senior) liquidation preference is detrimental to the holders of common stock.

I have seen somewhat similar provisions in the past in a slightly different context. In early stage Series A financings, some investors have tried to eliminate certain provisions, such as registration rights, from the standard documents to decrease the complexity and length of typical financing documents. However, these investors want the benefit of rights given to future investors. For example, I have seen a term sheet provision that provides for “most favored nation” status.

When the company raises a Series B financing, the terms of the Series A shall be amended to be at least as favorable as those granted to the Series B.

The problem with this provision is that it is not precise enough.  For example, one might interpret this to mean that price-based provisions (such as liquidation preferences) would be upgraded.

As an alternative, I have used the following term sheet provision in seed stage Series A financings where the investors received a Series A preferred stock with a liquidation preference and no other rights.

If the Company grants registration rights, information rights, rights of first offer, price-based antidilution protection, protective voting provisions or other similar rights to new investors in a subsequent financing involving the sale of additional series of Preferred Stock, the Company will use reasonable efforts to extend such rights to the Purchasers on the same basis granted to new investors. The Company also agrees to use reasonable efforts to provide that holders of greater than 400,000 shares of Preferred Stock will receive any rights customarily having minimum stockholding requirements.

In any event, I wouldn’t be surprised if more sophisticated early-stage investors that want to sell their stock prior to a sale of company or IPO started started asking for “upgradeable” preferred stock.