What are the pitfalls of converting early employees' common shares to preferred and then selling them to investors?

This is a question about private, VC-funded, growth stage companies. It seems to be a new trend to allow early employees to sell some of their shares when the company does a new funding round. For example, the company might issue new preferred shares totalling 5% to a new investor, but also "convert" 5% of the existing common shares owned by employees into preferred, and let employees sell those to the same investor. The theory is that (a) the investor gets that big 10% stake that they "need" (b) the company can tell itself that it's only taking 5% dilution (which is not really the case, I think) (c) early employees get some cash at the fancy, preferred price, almost always at a big premium on their common share strike price.

Is this a good idea or is the company better off just creating 10% new preferred shares and selling them directly to the investors?

This sort of founder/management liquidity (also known informally as "taking money off the table") is becoming increasingly common.

For a while, VCs tended to frown upon this (because they wanted to keep the team "hungry").

But, the current thinking is that in later rounds, letting the team sell some of their stock is a good thing for the business. The rationale is that if people have everything tied up in the business, they start making more conservative decisions (because they can't afford to lose it all). By letting them take a little bit of cash, their interests get better aligned with the investors.

Structurally, I'm not sure how these deals are done. I don't think it's really a "conversion" of common to preferred stock. I just think the common shares get "purchased" by either new investors or a combination of new and existing investors.

Also, in regards to dilution, having existing shareholders sell some of their stock in a new financing round does not cause dilution. Only the newly issued shares cause dilution.

The only pitfall that I see in a transaction that allows common stock to be sold at the significantly higher preferred price is that you may be setting a de facto new "fair market" price for the common stock, which could force you to adjust the strike price or exercise price of any new stock options you grant to match this preferred price. This would be a very undesirable as it would effectively remove the in-the-money value of the options you will grant, making them less valuable thereby requiring you to grant more of them to achieve the same level of incentive.

In order to avoid this, you should verify that the transaction you propose will not affect the exercise price and position the transaction as a one-time event that is necessary component of the financing you are carrying out, rather than as a bona-fide arm's length transaction between common shareholders and investors.

Interesting idea. It's kind of like an incremental payout for employees as the startup gets more mature and takes on investors as opposed to the big payout if there is an exit.

In theory, I don't see the dilution unless the present Preferred Shareholders have some sort of anti-dilution clause or preferred multiplier that has to be considered for the common to Preferred swap (in terms of fully diluted shares outstanding).

I don't know if a new Preferred investor would like that since the hook for employees to stay is diminishing over time.

Preferred stockholders also get special voting rights above and beyond common shares and option holders. That would have to be sorted out before conversion.

It's probably better for the company to just issue 10% more Preferred shares and maybe give employees cash bonuses or more stock options to keep it simple and clean.

I do think the idea has merit and it's a novel way to reward employees incrementally.