Shining a Light on Shadow Class Shares

What is Shadow Stock?

Shadow stock is a subclass of preferred stock that provides its holder the same rights and privileges of other preferred stockholders other than certain limited rights and privileges (i.e., liquidation and dividend rights), which are tied to the shadow stock’s original issue price. Shadow stock is called so because it is a “shadow” of a series of preferred stock issued by a company. Shadow stock usually takes on a hyphenated name after the corresponding preferred stock class. For example, shadow stock with rights similar to the Series B Preferred Stock of a company would be called “Series B-1 Preferred Stock”.

This article will explore how shadow stock is created and the purpose of shadow stock.

The Creation of Shadow Stock

Shadow stock is usually created when an emerging company previously issued convertible securities—such as SAFEs (Simple Agreement for Future Equity) or convertible notes (together, “convertible instruments”)—and is subsequently issuing a new class of preferred stock during an equity-raising round. Shadow stock is the class of preferred stock that is issued upon the conversion of these convertible instruments at a different original issue price than the price per share to be paid by the incoming investors in the preferred stock financing. The shadow stock’s original issue price is based on the valuation at which the convertible instruments converted into preferred stock based on a valuation cap or discount to the subsequent priced round (as described in the example below). This conversion generally occurs upon the initial closing of the priced round after the convertible securities were issued. Sometimes, however, convertible instruments included qualified financing requirements (including, a requirement to raise a certain amount of gross proceeds in the financing). In such instances, the convertible instruments will not convert into the requirements for conversion have been met. The shadow class shares are created and issued in tandem with the class of preferred stock issued in the priced round.

The Purpose of Shadow Stock

A well-known problem occurs when companies conduct early-stage financing rounds. To induce investors into making early-stage investments, a company may offer convertible instruments with a valuation cap, which sets the maximum valuation at which the convertible instruments will convert in a subsequent financing, or a discount. If the valuation in such subsequent financing is higher than the convertible instruments’ valuation cap, the earlier investors will be rewarded with a lower price per share. Likewise, the discount will reduce the price per share at which he convertible instrument converts into preferred stock.

This lower purchase price presents issues when the company exits and the shares (or the company’s business) is sold. The convertible instrument investors will have been issued preferred stock at a lower (or equal) price than the subsequent investors who purchased the preferred stock directly. If the convertible instruments convert into the same series of Series B Preferred Stock held by the subsequent investors, the convertible instrument investors would receive a liquidation preference which guarantees a substantial return (which results in varying treatment from the company’s investors that invested in its priced round), as illustrated by the following example:

An investor (“Investor A”) invests $50 into a company by purchasing a convertible instrument with a $10 million valuation cap. Then during the subsequent equity raising event, another investor (“Investor B”) purchases 100 shares of the company’s Series B Preferred Stock at $1.00 per share while the company has a pre-money valuation of $20 million. Investor A then converts its convertible instrument at the $10 million valuation into 100 shares of the same Series B Preferred Stock and winds up paying $0.50 per share (through the conversion of the convertible instrument) — 50% less than the price per share paid by Investor B. The company is then sold in a stock acquisition to an acquirer. The liquidation preference each investor will receive is based on the original issue price of the stock being sold. In this case, the original issue price of the Series B-2 is $1.00. As a result, Investor A and Investor B are both paid $100, but Investor A is doubling its original investment, whereas Investor B is only breaking even. This result is considered by many to be off market; as a result, adjusting the investors’ respective liquidation preferences will avoid deterring future investors in priced rounds.

The concept of a shadow class provides a solution to this issue. Instead of issuing to Investor A the same series of preferred stock (in the example above, Series B Preferred Stock) as Investor B receives, the company issues to Investor A a sub-series of preferred stock (“Series B-1 Preferred Stock”), that has all the same rights and privileges as the Series B Preferred Stock, including voting rights, information rights and, if applicable, ROFR and preemptive rights. The only difference is that the liquidation preference calculation and the basis for any dividend rights will be based on the discounted price that Investor A paid for its shares of Series B-1 Preferred Stock when Investor A converted its convertible instrument. In the example above, Investor A would receive only $50 ($0.50 per share price times 100 shares of Series B-1 Preferred Stock being sold), remedying the imbalance between the preferred stockholders that would otherwise result without the shadow class stock. Thus, shadow stock can serve an important function for any company looking to raise equity financing.

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