CCPS investments: an interesting alternative!

There are many ways to invest in a company. The regular way of investing involves an investor purchasing ordinary shares. However, the needs of the company or the investors may also make other ways of investing interesting. Examples include a convertible loan or the purchase of preference shares. There is also an intermediate form: Compulsory Convertible Preferred Shares (“CCPS”). In this article, I explain what CCPS are, how the mechanism usually works, what advantages they offer to the parties involved, what risks and negotiation points are involved, and how a CCPS structure is usually designed in Dutch legal practice.

What are CCPS?

In short, CCPSs mean that an investor first purchases preference shares, but that these are compulsorily converted into “ordinary” shares at a pre-agreed time or upon a pre-agreed event. It is also possible to convert to another type of share.

What exactly are preference shares? The word “preference” (or “preferred” in English) indicates that this type of share has special rights (for a certain period of time). For example, a liquidation preference, which means that there is a priority right to any proceeds from a sale/liquidation and/or a preference dividend. In Dutch, these types of shares are also referred to as preferential shares. In principle, it is up to the parties to agree on the special rights attached to a preferential share. A shareholder who holds preferential shares can therefore exercise these special rights.

‘Compulsory Convertible’ indicates that these preference shares do not remain preference shares permanently, but must be converted into ‘ordinary’ shares at some point. This instrument is therefore temporary in nature with regard to the preference of the shares. A shareholder who initially held preference shares and therefore also had special rights will, from the moment of conversion, only have the rights attached to ordinary shares.

How does a CCPS structure work?

In practice, a CCPS structure is primarily a combination of (i) preferential protection prior to conversion and (ii) a clear, mathematically verifiable conversion mechanism that determines what happens when a certain trigger occurs.

Preferential phase

During the period when the CCPS have not yet been converted, the investor is usually granted one or more preferential rights. The content of these rights varies per transaction, but the following elements are common:

• Liquidation preference. This is an agreement on the distribution of proceeds in the event of a “liquidation event”, such as the sale of (a substantial part of) the company, the sale of all or virtually all assets, or a formal liquidation. The investor then receives a payment up to a certain amount before (or in some variants: in addition to) the ordinary shareholders, often based on the amount invested (e.g. 1x, 1.5x or 2x), whether or not increased by accrued preferential dividends;
• Preferential (cumulative) dividend. Preferential dividend means that this dividend is paid first, before dividends on other shares. Cumulative means that undistributed dividends “accumulate” and may become payable at a later date (e.g. upon exit or conversion, depending on the agreements); and/or
• Protective provisions. CCPS in international transactions are often combined with protective provisions, such as approval rights for certain decisions, extensive information and reporting obligations and anti-dilution mechanisms.
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Conversion phase

The distinguishing feature of CCPS compared to, for example, a convertible loan is that conversion is mandatory. The parties specify one or more events in the documentation that automatically trigger conversion. In practice, the following triggers are common:

• a qualified follow-on investment, for example with a minimum size;
• an IPO (initial public offering);
• the expiry of a term (a long stop date), for example 18–36 months after issue; or
• a change of control or other event similar to an exit.

The reason for working with triggers is that they allow parties to link the preference phase to a moment when the company is more “mature”, its valuation is clearer and (often) a new group of investors joins. At that point, a cap table with one (or fewer) types of equity is usually desirable.

The conversion price and conversion ratio

The core of CCPS lies not only in the trigger, but also in the question of at what price and in what ratio the CCPS convert into ordinary shares. This is also where the economic incentive of the instrument lies. Sometimes the conversion is simple: a 1:1 conversion, whereby each preference share becomes one ordinary share. In many venture structures, however, the conversion is linked to the price of the next round, for example with a discount (e.g. 20%) or with a valuation cap. It also happens that accumulated preference (such as cumulative dividends) is “included” in the conversion. This may mean that the investor receives more ordinary shares upon conversion than in a pure 1:1 conversion. In such variants, it is crucial that the formula is unambiguous and that definitions such as “qualified financing”, “pre-money valuation”, “issue price” and “liquidation event” are clearly defined.

After conversion

After conversion, CCPS usually disappear as a separate class and the investor holds ordinary shares. However, governance agreements may continue to exist (in part) on the basis of the shareholders’ agreement, such as information rights or certain vetoes as long as an investor holds a minimum percentage. The underlying idea is that after conversion, the investor no longer has a ‘different’ economic position, but instead participates in the ordinary share structure. This simplifies subsequent rounds, often makes exit documentation less complex and prevents the accumulation of preferential layers.

Conclusion

The use of CCPS can be a useful tool in several phases of the company to attract new investors, whereby the investors initially receive slightly more rights. At the time of conversion, the investor will be a “normal” shareholder, but will already have benefited from developments that the company has undergone.

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