Convertible notes and Simple Agreements for Future Equity (SAFEs) are widely used by startups to raise early-stage capital. However, where the terms of those agreements are overly generous to the early-stage investor, those agreements can create complexities in future financing rounds, particularly in the form of “liquidation preference overhang”.

What is Liquidation Overhang?

Liquidation overhang occurs when the valuation cap (further explained in the SAFE article linked above) on a convertible note or SAFE is significantly lower than the company’s valuation determined in a subsequent financing round. This results in the note holders converting their debt into equity at a much lower price per share than new investors, potentially leading to a disproportionately high liquidation preferences for these early investors.

Illustrative Example

Consider the following scenario:

• A startup has 10,000,000 shares of Common Stock outstanding on a fully-diluted basis.
• The company raises $25,000 through a convertible note seed round with a $1,000,000 valuation cap.
• The $1,000,000 valuation cap implies a conversion price of $0.10 per share ($1,000,000 / 10,000,000 shares).
• Later, the company conducts a Series A round with a $20,000,000 pre-money valuation, resulting in a new investor price of $2.00 per share.
• The Series A Preferred Stock comes with a 1x participating liquidation preference, meaning each share has a $2.00 liquidation preference.

Upon conversion, the $25,000 in convertible notes will convert into 250,000 shares ($25,000 / 0.10 per share). Assuming these shares convert into the same Series A Preferred Stock as the new investors, the convertible note holders would receive a total liquidation preference of $500,000 (250,000 shares x $2.00 per share). This results in a 20x liquidation preference, which is significantly higher than the 1x preference for new investors.

Impact on Founders and New Investors

This scenario creates a substantial delta between the liquidation preference held by the new Series A investors and the Series Seed investors, where early convertible holders receive a liquidation preference far exceeding their initial investment. In a situation where the company undergoes a liquidation event, this overhang reduces the amount available to founders and new investors, potentially deterring new investment and complicating future funding rounds as a result of that relative lack of economic security.

“Shadow” Preferred Stock

One effective solution to address convertible note overhang is to create a sub-series of the Preferred Stock established in the priced financing round, known as “shadow preferred.” This sub-series, often labeled as Series Seed-2 or Series A-2, mostly mirrors the primary preferred shares, but takes on the liquidation preference, conversion price and dividend based on the actual price paid by the note holders, rather than the higher investor Series A price. This solution is actually now baked into the SAFE template distributed by YCombinator.

By creating a shadow preferred class, the convertible note holders receive the economic benefits of their lower conversion price without disproportionately impacting the liquidation preferences. This approach balances the interests of early note holders, new investors, and founders.

While this solution may solve for the primary underlying problem caused by liquidation overhang, founders should be careful not to create administrative and legal headaches by authorizing convertible instruments on a multitude of different terms, which may then lead to the need for extra classes of shadow preferred equity. These additional classes with disparate rights can complicate financing in future rounds.

Conclusion

Liquidation overhang can pose significant challenges in future financing rounds, particularly regarding dilution and liquidation preferences. Implementing strategies like shadow preferred stock can mitigate these issues, ensuring a fairer distribution of equity and protecting the interests of all parties involved. Understanding and addressing convertible note overhang early can save substantial legal and financial complications down the road, paving the way for smoother fundraising and company growth.