{"id":16940,"date":"2023-12-28T14:19:33","date_gmt":"2023-12-28T08:49:33","guid":{"rendered":"https:\/\/zerodha.com\/varsity\/?p=16940"},"modified":"2023-12-28T14:19:33","modified_gmt":"2023-12-28T08:49:33","slug":"why-vcs-get-compulsorily-convertible-preference-shares-and-not-equity-shares","status":"publish","type":"post","link":"https:\/\/zerodha.com\/varsity\/why-vcs-get-compulsorily-convertible-preference-shares-and-not-equity-shares\/","title":{"rendered":"Why VCs get Compulsorily Convertible Preference Shares and not Equity shares?"},"content":{"rendered":"

In an earlier blog<\/a>, we discussed the difference between Compulsorily Convertible Preference Shares (CCPS) and Common Equity briefly. But this topic deserves a short blog to describe some of the structural reasons around the classification and why VCs opt for CCPS over common equity.\u00a0<\/span><\/p>\n

Compulsorily Convertible Preference Shares (CCPS) are a type of preference shares issued by a company with a mandatory conversion feature. These shares are a hybrid financial instrument that combines elements of both preference shares and convertible debentures. CCPS has precedence over common equity shareholders in two ways – before paying any dividends to equity shareholders, CCPS holders receive dividends, and if the company goes bankrupt and has to sell its assets, CCPS holders will receive a return on their capital on a priority basis when compared to the other shareholders.<\/span><\/p>\n

\"\"<\/p>\n

In comparison to common equity holders, who get to vote on all resolutions, CCPS holders are generally limited to voting on matters affecting their rights as shareholders or matters affecting the rights of the class of shares that they hold, all of which are detailed in the shareholder agreements.\u00a0<\/span><\/p>\n

What are some of the rights that come along with CCPS?\u00a0<\/i><\/b><\/p>\n

    \n
  1. \n
      \n
    1. Conversion Conditions:<\/b> Shareholders can define the conversion ratio (usually 1:1)\u00a0 and trigger events for conversion, including a specific timeframe, the achievement of milestones, or the occurrence of a predetermined event like a financing round.<\/span>
      \n<\/span><\/li>\n
    2. Anti-Dilution Protection:<\/b> CCPS agreements may include anti-dilution provisions to protect investors from dilution in the event of future equity issuances at a lower valuation.<\/span>
      \n<\/span><\/li>\n
    3. Liquidation Preferences:<\/b> While it’s commonly known that preference shareholders have priority in receiving their capital back during liquidation, the exact terms of the liquidation preference can vary.<\/span>
      \n<\/span><\/li>\n
    4. Down Rounds Impact:<\/b> In the case of a down round (where the company’s valuation decreases), the conversion terms can lead to a higher number of equity shares being issued to CCPS holders, potentially diluting existing shareholders more than anticipated.<\/span>
      \n<\/span><\/li>\n
    5. Board Representation and Voting Rights:<\/b> CCPS agreements may grant investors certain governance rights, such as the ability to appoint a board member or special voting rights. These provisions can impact the decision-making process and should be clearly understood.<\/span>
      \n<\/span><\/li>\n
    6. Redemption Rights:<\/b> While less common, some CCPS agreements may include provisions allowing the investor to demand redemption of the shares under certain conditions.\u00a0<\/span><\/li>\n<\/ol>\n<\/li>\n<\/ol>\n

      What are some of the challenges with CCPS?\u00a0<\/i><\/b><\/p>\n

        \n
      1. \n
          \n
        1. Limited Control for Preference Shareholders:<\/b> While CCPS holders have preference rights, they may have limited or no voting rights until conversion. This means that, until conversion occurs, preference shareholders may not actively participate in certain key company decisions.<\/span>
          \n<\/span><\/li>\n
        2. Complex Structuring:<\/b> The structuring of CCPS agreements can be complex, and the terms may include various provisions such as anti-dilution mechanisms, liquidation preferences, and conversion conditions. Navigating these complexities requires careful negotiation and legal expertise.<\/span>
          \n<\/span><\/li>\n
        3. Uncertain Future Capital Structure:<\/b> Until conversion occurs, the company operates with a hybrid capital structure that includes both preference and equity shares. This can complicate financial reporting and impact the company’s ability to attract additional investors.<\/span>
          \n<\/span><\/li>\n
        4. Limited Exit Options:<\/b> In some cases, CCPS agreements may restrict exit options for investors, making it challenging for them to sell their shares before conversion.<\/span><\/li>\n<\/ol>\n<\/li>\n<\/ol>\n

          Here are a couple of further reads on this topic,\u00a0<\/i><\/b><\/p>\n

            \n
          1. From Cyril Amarchand Mangaldas\u00a0<\/span><\/a><\/li>\n
          2. From ICAI<\/span><\/a><\/li>\n<\/ol>\n

            This is Dinesh Pai’s eighth post in the Venture Capital<\/a>\u00a0category. Dinesh heads investments for Rainmatter and is an avid\u00a0blogger<\/a>.\u00a0<\/em><\/p>\n","protected":false},"excerpt":{"rendered":"

            In an earlier blog, we discussed the difference between Compulsorily Convertible Preference Shares (CCPS) and Common Equity briefly. But this topic deserves a short blog to describe some of the struct .. <\/p>","protected":false},"author":113847,"featured_media":0,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"footnotes":""},"categories":[973],"tags":[1050,1049,1023,974,971],"class_list":["post-16940","post","type-post","status-publish","format-standard","hentry","category-venture-capital","tag-ccps","tag-preference-shares","tag-vc","tag-vc-firms","tag-vcs"],"yoast_head":"\nWhy VCs get Compulsorily Convertible Preference Shares and not Equity shares? –<\/title>\n<meta name=\"robots\" content=\"index, follow, max-snippet:-1, max-image-preview:large, max-video-preview:-1\" \/>\n<link rel=\"canonical\" href=\"https:\/\/zerodha.com\/varsity\/why-vcs-get-compulsorily-convertible-preference-shares-and-not-equity-shares\/\" \/>\n<meta property=\"og:locale\" content=\"en_US\" \/>\n<meta property=\"og:type\" content=\"article\" \/>\n<meta property=\"og:title\" content=\"Why VCs get Compulsorily Convertible Preference Shares and not Equity shares? –\" \/>\n<meta property=\"og:description\" content=\"In an earlier blog, we discussed the difference between Compulsorily Convertible Preference Shares (CCPS) and Common Equity briefly. 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