Thought this was interesting for those like me who are new to this world......
Converting Preferred Stock to Common stock typically occurs in the case of a liquidity event (i.e. Acquisition or IPO). Since the conversion is typically forced in the case of an IPO, we'll focus on an acquisition scenario.
Preferred shareholders commonly have what is known as a Liquidity Preference, which gives them the right to recoup a certain dollar amount before Common Shareholders receive anything. The most common liquidity preference nowadays is 1x, meaning Preferred shareholders receive their original investment before common receives anything.
Let's look at two scenarios:
1) Preferred does not want to convert to Common
Original investment: $1,000,000
Preferred Shares: 10,000
Common Shares: 10,000
Post-money Valuation: $2,000,000
Liquidity Preference: 1x
Acquisition Price: $500,000
Liquidity Preference of Preferred = $500,000
If they converted to common = $250,000
2) Preferred wants to convert to Common
Original investment: $1,000,000
Preferred Shares: 10,000
Common Shares: 10,000
Post-money Valuation: $2,000,000
Liquidity Preference: 1x
Acquisition Price: $4,000,000
Liquidity Preference of Preferred = $1,000,000
If they converted to common = $2,000,000
Liquidity preference is in place as a protection for the investor and they will typically convert to common in a successful acquisition.
Another form of Preferred stock, known as Participating Preferred, is a bridge between the two scenarios by allowing the investor to double dip. In the case of a Participating preferred, the investor would be able to recoup their liquidation preference AND share in splitting the proceeds with Common Shareholders. The above example would look as follows for Participating Preferred (note: only #2 will change):
Participating Preferred:
Original investment: $1,000,000
Preferred Shares: 10,000
Common Shares: 10,000
Post-money Valuation: $2,000,000
Liquidity Preference: 1x
Acquisition Price: $4,000,000
Liquidity Preference = $1,000,000
Participating Preferred = 50% * $3,000,000 = $1,500,000
Total Participating Preferred = $2,500,000
