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What is a Convertible Note?

What is a Convertible Note?

Originally posted July 14, 2015 on the Tech Ranch Austin Blog.

Convertible notes can be a challenging topic for both entrepreneurs and investors. Entrepreneurs seeking investors often solicit convertible notes without knowing why they should use one. Likewise, many investors do not truly understand the convertible notes they are asked to sign. In this blog post I will describe convertible notes and explain how they work and when to use one.

First, let’s define a convertible note. It’s called “Convertible” because it may convert into equity. “Note” refers to a document, often called a “promissory note,” that records a loan and its repayment terms. A convertible note is a document that reflects two different transactions: a grant of money in exchange for repayment terms, and the option to convert the loan principal and interest into stock in the company that accepts the grant. Pretty simple, right? Yes and no.

Let’s dive into an example to understand further. If I am an entrepreneur, I need money. Let’s say I need $20,000 to get me going. It would be great if someone would loan me the money on friendly terms with no history of operating income, but I likely won’t get that at a bank. So instead, I will seek an investor. My investor may say, “I’ll lend the $20,000 to your company, knowing that it’s quite a big risk I won’t get it paid back, BUT if I am taking that risk I want you to cut me a deal. I want the ability, at some predetermined event, to have the money I lent you and the interest accrued, to buy equity in your company later down the road. And I’d like to be able to buy at a discount.” This is where the convertible note terminology comes in.

On its face it seems fair. Or you may be asking, “Why even do it? I might as well just sell stock to this person.” Entrepreneurs and investors frequently use convertible notes because they are relatively easy to do and generally save on legal expenses. They also avoid a discussion and negotiation about how much the company is really worth.

Convertible notes can be great choices for a company that may later reach a larger valuation at an equity triggering event in a short amount of time (within the time limit before the note becomes due). It is worth pointing out that only in rare instances does the convertible note get paid back on the original note terms without conversion. The investor does not enter the deal hoping to get paid back on a loan. The investor is usually looking to make an equity investment in the Company, and knows that repayment of the convertible note when it’s due is unlikely.

The convertible note offers the flexibility to add terms that make it more than just a simple matter of applying principal and interest to purchase of stock. The most common additions made are:

1.       Triggering event – The trigger that will cause conversion to equity. The most common is an equity financing, usually the next round of financing that the company anticipates raising. In this case the conversion happens automatically. Usually the financing round has a minimum size before triggering conversion. The conversion will take place at the same price (normally less a discount) paid by other investors in the financing round, and the investor gets the same type of stock or other security as the other participants in the financing round. Mergers and other exit events can also be triggers.

2.       Optional conversion by investor – This provides an option for the investor if the company never has a triggering event and the company is sold, or the company is doing great but the note matures before a triggering event.

3.       Discounting – Normally, the purchase price of stock at a triggering event will be discounted by an amount within the 10-30% range from the price paid by other investors.

4.       Cap – Sometimes the investors push for a price cap on the valuation used on determining the conversion price to prevent them from paying too much per share if the company hits a home run.

5.       Maturity date – The maturity date for the loan is often negotiated and generally runs from several months to several years.

6.       Interest rate – As with any loan agreement the interest rate on the principal amount of the loan is negotiable. It can vary widely from 2 to 12 percent although 6 percent is common.

There are other reasons the convertible note is appealing. The debt treatment of the investment avoids having a price set for the company’s equity, which can be helpful for tax purposes if the company issues stock options or restricted stock. Oftentimes, entrepreneurs like the idea of the convertible note because, aside from the cost savings on legal, he or she does not have to price the company’s equity before he or she knows how much the company will be worth when it raises more equity. Investors on the other hand get a discount on the conversion, and a senior debt position if there is a liquidation. They can protect themselves with a cap from paying too much per share if the Company does extremely well.

LEGAL DISCLAIMER: This article is not intended to be, nor may it be used as, legal advice or tax advice.  This article shall be used solely for general, non-directed informational purposes.  No attorney-client relationship has been formed by virtue of this article and Ressler + Wynne Ressler, PC has in no way agreed or consented to provide you with legal representation by virtue of this article.