Convertible notes remain one of the most prevalent forms of early-stage financing, valued for their simplicity and efficiency. However, one feature often raising questions among investors and founders alike is the “shadow series” provision. In this article, we clarify the shadow series provision, why it is included in convertible notes, and how it impacts both investors and companies during a Qualified Financing.
What is the Shadow Series Provision?
The shadow series provision allows a company to issue a newly created series of preferred stock specifically to convertible noteholders when their notes convert into equity. Rather than converting directly into the exact series of preferred stock being purchased by new investors, noteholders receive a separate, nearly identical class of shares with slightly adjusted economic terms.
Why is the Shadow Series Provision Important?
The core rationale behind the shadow series provision lies in preserving fairness and maintaining investor alignment. When convertible notes convert at a lower share price—often due to negotiated valuation caps or discounts—giving noteholders the identical preferred stock as new investors could unintentionally offer overly favorable economic terms to those earlier investors.
To address this:
- Proportional Adjustment: The shadow series adjusts key economic terms such as liquidation preferences and dividends proportionally based on the noteholders’ lower conversion price.
- Investor Alignment: This structure helps mitigate potential friction or valuation concerns that new investors might have, particularly if earlier investors appear to receive disproportionately favorable terms.
- Fairness: It ensures fairness across all investor groups, honoring the economic intent of the original convertible note agreement while not disadvantaging new capital entering the business.
Example of the Shadow Series in Action
To illustrate, consider a scenario where new investors participate in a Qualified Financing at $1.00 per share, while earlier convertible noteholders convert their notes at $0.80 per share (due to a discount or valuation cap).
Under a shadow series arrangement:
- Liquidation Preference Adjustment: Instead of a $1.00 per share liquidation preference, noteholders receive shares with a $0.80 liquidation preference, aligned with their conversion price.
- Dividend Adjustment: Dividend rights might also be proportionally scaled based on the lower conversion price.
- Governance Parity: Governance rights, voting privileges, and other non-economic terms typically remain consistent with the new investors’ series of shares, maintaining investor unity in corporate governance.
Strategic Considerations for Founders and Investors
Founders and investors should keep the following points in mind:
- Transparency: Clearly communicate the rationale and mechanics of the shadow series to all stakeholders early in the financing process.
- Balance: Ensure the shadow series structure appropriately balances the economic interests of early supporters and new investors, safeguarding future funding rounds.
- Flexibility: Leverage the shadow series to facilitate smoother negotiations and quicker closings during financing rounds by preemptively addressing potential investor concerns.
Final Thoughts
Incorporating a shadow series provision into convertible notes is a strategic choice that aligns the interests of all investors, ensures fairness, and maintains the attractiveness of the company to future capital. Understanding and effectively communicating the rationale behind this provision can significantly enhance investor relations and streamline future financing efforts.
At Veritas Global, we specialize in structuring and negotiating early-stage financing arrangements that align with your company’s growth objectives and investor expectations. To discuss how convertible notes and shadow series provisions can strategically benefit your fundraising plans, schedule a consultation with our experienced team today.
