Convertible shares explained: how they convert to ordinary shares and why VCs want them

Convertible shares are shares that start life as preference shares and carry an option to convert into ordinary shares later. Investors like them because they get paid first if the company struggles, and they can switch to ordinary shares to share fully in the upside if it succeeds. If you are heading into a funding round, here is what convertible shares are, how the conversion works and who they are designed for.

What are convertible shares?

Convertible shares are typically preference shares that come with the option to convert into ordinary shares.

Preference shares are a special class of shares with preferential rights to dividends and capital distributions. In short, that means two things:

• Dividends. Preference shareholders are the first to be paid a fixed amount of dividends.
• Capital. If the company is liquidated, its assets sold off and the proceeds distributed to shareholders, the holders of preference shares are the first to receive that money. Only if there is anything left does it go to the rest of the shareholders.

So a preference share is about priority. The holder stands at the front of the queue. Ordinary shares, by contrast, come with no fixed dividend and no priority on a liquidation, but they take whatever is left once the preference shareholders have been paid, and that "whatever is left" is where the real growth sits in a successful company.

A convertible share, then, is a preference share with a door built into it. The investor walks in holding priority and a fixed return, and at a point of their choosing, within the rules set out in the contract, walks through the door into ordinary shares. Understanding the two rooms on either side of that door is the key to understanding why these shares exist.

Downsides of preference shares

The downside of preference shares is typically twofold.

First, they usually do not carry the right to vote. From a founder's point of view that can be a positive, because it means raising money without giving up control of the company. From the investor's point of view it is a limitation.

Second, the capital growth opportunities are lower. Yes, preference shareholders are preferred in the sense that they get paid first, but the amount they get is capped. There is a ceiling on their return. If the company does well and there is, for example, a large pool of dividends to distribute, the ordinary shareholders typically benefit more, because they receive everything above what is paid to the preference shareholders.

Why investors prefer convertible shares

That cap is exactly why investors such as venture capital firms like convertible shares.

If things are not going well, the investor keeps their preference shares and with them their greater right to receive dividends and capital distributions ahead of everyone else. If things are going well, and there is, for example, an exit or a sale of the company, the investor converts into ordinary shares shortly before the sale so that they receive the maximum amount of money possible from it.

In other words, the investor gets to choose the better of two positions depending on how the company has performed.

Think about it from the investor's side. They are putting money into a company with no track record. If it fails, they want to be at the front of the queue for whatever is recovered. If it succeeds, a capped preference return would mean missing out on most of the value they helped to create. A straight preference share solves the first problem but not the second; a straight ordinary share solves the second but not the first. A convertible preference share solves both, which is why it has become the standard ask from this type of investor.

Downside protection vs upside gain

To summarise the trade-off: convertible shares start out as preference shares at a point when it is still not clear how well the company is going to do. At that stage the investor wants to be the first to get paid if, say, the company is liquidated and its capital is distributed. That is the downside protection.

If instead things go well, there are a few funding rounds and the company grows a lot, the holder of the preference shares may want to convert them into ordinary shares. Ordinary shares carry greater risk, because there is no priority and no fixed return, but they also carry greater rewards. An investor would only convert if they deem the risk to be lower than it was at the start, because the company has already shown it is doing well. That is the upside gain.

For a founder, this means the investor's rights change shape over the life of the investment. In the early years you are dealing with a preference shareholder with a fixed return and usually no vote. After conversion you are dealing with an ordinary shareholder who shares in the growth. Both scenarios need to be understood before you sign.

How do convertible shares convert? Trigger events

In practice, the shares start out as preference shares and receive a fixed amount of dividends. Conversion happens on a trigger event.

The contract with the investor will typically specify which events act as triggers that allow the investor to convert their preference shares into ordinary shares. When one occurs, the process is usually:

• Notice. The investor gives the company notice that they are exercising the right to convert.
• Compliance. The company must comply with that notice, take back the preference shares and issue ordinary shares in their place.

Trigger events are typically things like:

• A sale of the company. The investor converts shortly before completion so they take part in the sale proceeds as an ordinary shareholder.
• An IPO. An initial public offering, where the company lists its shares.
• A significant funding round. A new round of investment large enough to show the company is on a strong trajectory.

The exact list of triggers, and whether conversion is at the investor's option or automatic, is a matter for negotiation and must be set out clearly in the investment documents and reflected in the articles of association. From the company's side, the mechanics also need to work: the articles need to create the preference class with the conversion right attached, and the company needs to be able to issue the ordinary shares when the notice arrives. Those are drafting points, but if they are missed the conversion can stall at exactly the moment, a sale or a funding round, when everyone needs it to go smoothly.

Who uses convertible shares? Startups and VCs

There are two parties to think about: the company issuing the shares and the investors receiving them.

On the company side, convertible shares are typically used by start-up-like, early-stage companies. These companies are often unable to raise enough debt finance, in other words loans from banks, and instead have to turn to the equity markets, such as venture capital firms, to fund their growth. Convertible shares give those investors a package attractive enough to invest in a business without a track record.

On the receiving end of the share allotment, the people taking the shares are typically sophisticated investors. They might be venture capital firms investing their own investors' money, or angel investors. Typically these are savvy individuals who understand how equity works and want to protect their interests while maximising their chances of a return on the investment.

In my experience, if you are a founder dealing with this type of investor, expect them to ask for convertible preference shares as a matter of course. Understanding why they want them puts you in a much better position to negotiate the terms: the fixed dividend, the trigger events and the voting position.

Next steps

If you are preparing for a funding round, read the term sheet carefully for the preference rights, the conversion triggers and whether the investor shares carry votes. Make sure your articles of association are updated to create the preference class with the conversion mechanism built in, and have a corporate solicitor review the investment agreement before you commit. For background on the share classes involved, see ordinary shares vs preference shares and how to create different classes of shares.