A financial sponsor is offering us a seller note that converts to common equity if they execute a subsequent recapitalization before the note matures. How do we structure the conversion terms and valuation floor to prevent our debt from being wiped out or heavily diluted?

Question

Tyler Smith · Accepted Answer

This is a classic financial sponsor tactic to conserve cash while dangling the carrot of upside. The problem is that without strict protections, a subsequent recapitalization can trigger a conversion at an inflated valuation, leaving you with worthless minority paper and zero liquidity. You must negotiate a hard valuation floor and a clear conversion formula up front. Tie the conversion price to the lower of a pre-agreed multiple of EBITDA or the enterprise value established in the new financing round. Additionally, insist on a liquidation preference. If the sponsor recapitalizes the business, your converted equity must sit senior to their common equity, ensuring you get paid first in a liquidity event. Use your V/TO® to model out these scenarios and understand your minimum acceptable exit value. Do not let them use vague definitions of fair market value. Your leadership team must run this through your weekly Level 10 Meeting™ and use IDS® to pressure-test the buyer's conversion scenarios. If they refuse to grant a liquidation preference or a reasonable valuation floor, reject the conversion feature and demand a straight cash-pay note with a market-rate PIK interest kicker to compensate for the risk.