For SAFE investors and issuers who want to understand the mysterious Shadow Stock, a series of preferred stock that is created when a SAFE is converted into equity at a triggering priced round.
First, Shadow Stock ≠ Phantom Stock
Shadow Stock is often confused with Phantom Stock, likely because of the mysterious names. However, the terms are not the same and should not be used interchangeably.
Phantom stock is not actually stock; it is a form of equity compensation given to key employees entitling them to benefits that act like stock.
Shadow stock is a real class of preferred stock that shadows another series of preferred stock, with all of the same rights and preferences, but with a certain differences which correlate to the price per share that was actually paid for the shadow stock (usually at a discount to the preferred stock it shadows).
You can remember the difference this way:
Phantoms are not real
a phantom is something that seems real, but does not exist.
Phantom Stock ⇢ a faux "stock-like" equity incentive given to key employees instead of real equity/stock (to avoid dilution).
Shadows are real (basically):
a dark shape on a brighter surface caused by the blocking of a light source; a shadow will have the same shape as the object causing it.
Shadow Stock ⇢ a real class of stock that shadows a series of preferred stock and is created at the conversion of a SAFE into equity (it's a sub-series of preferred stock).
Now that you understand the difference, what is shadow stock?
Back to Basics: Why SAFEs Were Created
A SAFE ("Simple Agreement for Future Equity") is a simplified, standardized alternative to traditional convertible notes that was drafted to mitigate certain issues that arise with traditional convertible notes.
Convertible notes are considered "debt instruments" rather than equity because repayment is a potential outcome. Generally, a convertible note will either be (a) converted into equity at a “qualified financing” (a priced round above a certain amount as set forth in the note), or (b) repaid, plus accumulated interest (like a traditional loan) on the maturity date.
The maturity date eliminates some of the risk for the investor, and causes the convertible note to act more like a loan (debt). Regulations and requirements for debt instruments can make life more complicated for a startup.
SAFEs on the other hand, are generally not considered debt instruments because there is no maturity date and SAFEs are never repaid (very unlike a loan). SAFEs will only convert into equity if and when the company has a priced round.
Not using a debt instrument to raise funds alleviates certain regulatory issues and financial pressures for the company. For example, a looming maturity date may divert the founder's focus from R&D toward raising an equity financing round above the amount required to trigger conversion of the note, which the company may not be ready for. Rushing a financing deal is not a good position for the startup. The founders may focus solely on achieving enough profitability to be able repay the loan (if it can) or become insolvent.
Aside from these debt related issues, traditional convertible notes also have some “unfairness" issues.
Liquidation Preference Issues
SAFEs and convertible notes can have a valuation cap and/or a discount rate. If the instrument contains both, it will convert at whichever method gives the holder a lower purchase price per share (better deal).
And, this is where SAFEs and traditional convertible notes diverge in their conversion mechanics:
At the triggering financing, convertible notes are issued the exact same series of preferred stock as the priced round investors, so that there is only one new preferred series on the cap table. Therefore, the convertible note holder will receive the exact same liquidation preference as the new investors.
This means that, in a liquidation event, all of the preferred stock in this series will be paid out based on the "original issue price" (the price per share paid by the new investors). However, the convertible note holders paid a lower price per share than the new investors due to the convertible note's valuation cap or discount rate, whichever was used. Thus, the convertible note holders paid less per share for the preferred stock than the priced round investors, but will get the same payout as the priced round investors.
For example, let's say that the new investors paid $1.00 per share and the convertible note holders (who had a 20% discount) actually paid $0.80 per share. Now, the convertible note holders will be paid out as if they had paid $1.00 per share. In other words, they will get more payout than they are entitled to because the payout amount is not pegged to the amount they actually paid per share.
SAFE Conversions: Shadow Stock
Conversely, when a SAFE converts into equity, a shadow series of preferred stock called the "SAFE Preferred Stock" is issued to the SAFE holders ("the Investor") and is distinguished from the preferred stock issued to the priced round investors ("investors investing new money in the Company") by the creation of a separate series of preferred stock called the "Standard Preferred Stock."
In startup law, the "SAFE preferred stock" issued to the SAFE holders ("the Investor"") is also called "shadow stock," “shadow preferred stock," or “sub-series preferred stock" (called just "shadow stock" in this post for simplicity).
On the startup's cap table, the shadow stock may be under a sub-label (e.g., “Series A” for the standard preferred, and “Series A-1” for the shadow preferred), or it may be labeled as a separate series (e.g., “Seed-1” for the new money investors, and ‘Seed-2’ for the SAFE investors). The labeling is just semantics and generally just depends on the lawyer's preferences.
The new shadow stock has "identical rights, privileges, preferences and restrictions as the Standard Preferred Stock" . . . with an important exception – the calculation for the liquidation preference and any dividend will equal the "Discount Price."
The Discount Price is based on the original issue price that the SAFE holder actually paid for the shares when the SAFE converted, not the price paid by the priced round investors (e.g., $0.80 per share for the SAFE holders vs $1 for the new money investors).
Thus, the liquidation preference and any dividend owed to the shadow stock (SAFE investors) correlates to the amount the SAFE holder actually paid to purchase the preferred shares in the startup in the conversion of the SAFE, which solves an inequity caused by the mechanics of convertible notes and is considered much more fair for the priced round investors and the common shareholders (the founders and employees).
It should be noted that many startup lawyers (but not all) now add a shadow stock clause to traditional convertible notes to resolve this issue. If you are raising funds through a convertible note round, be sure to discuss this issue with your lawyer.
Relevant Reading:
Disclaimer: The information on this website is meant to be used for general educational purposes only. This information may not reflect the current law in your jurisdiction and should not be construed as legal or business advice or an advertisement for legal services. You should not act or refrain from acting on the basis of any information in this post or accessible through this website. If you have questions regarding your particular facts and circumstances, seek counsel from an experienced startup lawyer.