So why do Investors take Convertible Stock in Startups?

Hello viewers, welcome to Info Thirst. Today, we are going to discuss about convertible preference shares . Before we get into the topic we would like you to Follow us by clicking the follow button. Now that you have done that...So let's dive into it…

One question that comes up very often is why do startups issue convertible stock to investors? So why is it convertible preferential? Why is it convertible debenture? The reason for it is simple and actually, quite interesting. The investors are trying to protect their downside while at the same time also ensuring that they get all possible benefits of an upside. Now imagine an investor puts in 20,000 rupees at a valuation of one lakh, which means he's getting 20% of the company. Now this has been put in the form of convertible preference shares. Let's take one scenario, two - three years down the line. The company hasn't performed very well and is looking for a buyer, the buyer offers a price of forty thousand for the company. Earlier the company, which was once valued at one lakh when the investor had put in 20,000 and acquired the 20% of the company. Now because the investor has preferential preference shares, he has a liquidation preference, Which means, from the 40,000 that comes in. he takes away, his entire 20000 away. And what is left from that 40,000 is just a 20,000, which all other Founders shareholders split amongst themselves. (If he were to convert his shares to equity and want a payout in proportion to his holding, he would only get eight thousand - 20% of that 40,000). Hence investors do not convert to equity. They prefer to use his preference right. 

In another scenario, the company is sold for 10 lakhs. Now, if the investor were to convert his shares to equity at 20%, He will get 20% of 10 lakh which is 2 lakh rupees, which is 10 times the amount that he invested. So he's not going to use his preference rights, he is going to convert to equity and take the benefit of that upside and take away 2 lakh and not 20,000. So the preference right helps investors safeguard their downsides and the conversion to equity element gives maximum benefit of upside. 

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