Mechanics of conversion: Overview, definition, and example
What are the mechanics of conversion?
The mechanics of conversion refer to the specific process and conditions under which one type of financial instrument, such as a convertible note or preferred stock, is converted into another form, typically equity. These mechanics outline the timing, pricing, and procedures governing the conversion to ensure transparency and fairness for both the company and the investor.
For example, in a convertible note agreement, the mechanics of conversion specify when and how the noteholder's loan is converted into company shares, including the conversion price and any applicable discounts.
Why are the mechanics of conversion important?
The mechanics of conversion are essential because they define the rights and obligations of both the company and the investor when converting securities. A well-structured conversion process ensures fairness, reduces disputes, and helps businesses raise capital without immediate dilution.
For investors, understanding these mechanics helps them assess the potential value of their investment and the conditions under which they receive equity. Without clear mechanics of conversion, disagreements may arise over pricing, timing, or the number of shares issued.
Understanding the mechanics of conversion through an example
Let’s say an investor loans $100,000 to a startup through a convertible note, with the agreement that the note will convert into equity if the startup raises at least $1 million in a future funding round. The mechanics of conversion specify:
- The conversion price, which is set at 80% of the price paid by new investors in the funding round (a 20% discount).
- The conversion trigger, meaning the conversion occurs automatically when the startup raises $1 million.
- The number of shares issued, which depends on the note's value divided by the conversion price.
In another example, a company issues preferred stock that allows investors to convert their shares into common stock if the company goes public. The mechanics of conversion determine the exchange rate between preferred and common shares and account for adjustments like stock splits.
An example of a mechanics of conversion clause
Here’s how a mechanics of conversion clause might appear in a contract:
“Upon the occurrence of a Qualified Financing Event of at least [$X] million, the outstanding principal and accrued interest under this Note shall automatically convert into shares of the Company’s Preferred Stock at a conversion price equal to [X]% of the price paid by new investors. The conversion shall take effect upon the closing of such financing, and the Investor shall receive a pro-rata allocation of shares based on the converted amount.”
Conclusion
The mechanics of conversion establish the framework for transitioning financial instruments into equity, ensuring clarity and fairness in investment agreements. Whether in convertible notes, preferred stock, or bond conversions, defining the conversion process prevents disputes and protects both investors and companies. Before entering into such agreements, all parties should carefully review the mechanics of conversion to fully understand their rights, obligations, and financial outcomes.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.