A conversion is the right of preferred shareholders to convert their shares into common stock at any time.
The most common conversion rate is 1:1, which means that one share of preferred stock will convert into one share of common stock. Once a preferred share is converted into a common share, there is no provision to converting it back. This term is standard and really one of the only truly nonnegotiable terms. The conversion is a relinquishing of all the rights and privileges of preferred shares, so this doesn’t have a negative impact on the entrepreneur.
So, why would a shareholder choose to give up their preferences? A preferred shareholder is usually motivated to convert his or her shares into common stock in a liquidity event. A preferred shareholder has the right to convert in a liquidity event if it produces a better-off outcome. Assuming the conversion rate is 1:1, a preferred shareholder who owns 60% of the company can convert his or her shares into common shares and still own 60% of the company. After the conversion, the preferred shareholder can take 60% of the proceeds of a sale of the company. However, the converted shareholder would lose all the special rights negotiated under the preferred shares. In some rare occasions, a preferred shareholder might choose to convert into a common shareholder in order to control a vote on a certain issue.
In some instances, preferred shareholders automatically convert to common stock. The function of the automatic conversion is to force all preferred shareholders to convert into common stock as most companies go public with a single class of common stock as opposed to multiple classes of stock. Some components of an automatic conversion are negotiable, and the most critical element is the threshold for the automatic conversion.
The trigger of an automatic conversion is usually referred to as a qualified IPO. A qualified IPO would include a public offering of common stock of the company of no less than a negotiated price per share. This negotiated price acts as a threshold for conversion to protect preferred shareholders from being forced to convert if the price per share is too low.
In the Series Seed term sheet, the conversion preference is as follows:
Conversion: Convertible into one share of Common (subject to proportional adjustments for stock splits, stock dividends and the like) at any time at the option of the holder.
Thus, the investor has the option to convert each share of preferred stock into a share of common stock at any time.