What Is a Convertible Note?
A convertible note is defined as a financing option available to a company. It is a short-term loan where the investor advances funds to the company and has the option of converting it into equity at a later date. The repayment of the loan here is not in terms of principal and interest but equity stake in the company. Most angel investors use this method of convertible note investment when investing in startups that do not have a clear valuation.
It can be better understood with a convertible note example. Suppose a company issues such note to an investor A for $100,000. It offers a 20% discount on the price per share. Let’s say the price of a share is $10. Applying the discounted rate, A will get one share at $8. The total shares A will get is 12500, compared to only 10000 shares that another investor B who may invest in the company later will get.
Terms in Convertible Note
Some of the key terms in a convertible note template are:
- Names of the parties
- Definition of terms used
- Description of the loan given under the note
- Security for the loan, if any
- Interest rate
- Date of maturity of the note
- Provisions detailing the conversion of the loan into equity
- Valuation cap
- Conversion discount
- Rights of the investor
- Representations and warranties by the parties
- Events of default
- Confidentiality
- Signatures of the parties
Drafting a Convertible Note
The below points should be considered while drafting a secured convertible note:
- Clearly state the amount of loan that the investor has advanced, the rate of interest, and the maturity date of the loan. If the loan is given for a particular purpose, it should be stated in the note.
- Include a provision stating whether the note will automatically convert to equity upon maturity or will the parties decide whether the investment gets repaid or converted.
- Mention the events under which the loan will be converted to equity. This generally occurs during an initial public offering (IPO), or a qualifying round where the company issues shares to investors in return for money or during the maturity of the note.
- Clearly, state the valuation cap. It is a cap on the maximum price that the note will convert into equity. It allows the investors to convert the note into equity at a lower price than that offered in the subsequent financing round. It essentially means that an investor gets the same benefits as if he were purchasing shares in the subsequent round. This serves as an appropriate reward for the early risks that they take in investing in the company.
- Along with the valuation cap, the conversion discount must be mentioned with certainty. This discount is given to the investors when their investment is converted to equity. Thus, they get more shares at a discounted price for backing the company.
- Mention the representations and warranties given by the parties. These include statements of facts about the business and operations of either party. They help the other party to make a decision and enter into a contract. In this case, one of the representations by the company will state that the note is validly issued in compliance with all relevant laws. The investor will represent, among other things, that it has the authority to execute the transaction.
- State the events of default and their consequence for either party. For example, if the company becomes bankrupt, the investor can, under the terms of the note, possess the right to demand repayment of the note.
- Include a provision for confidentiality that prevents disclosure of any information related to the issuance of the note to a third party without the consent of the other party. In case disclosure is required by law, the parties should come together and discuss the issue at a reasonable time before the disclosure is made in the court.
Since such a note qualifies as a security under the federal and state laws(1), it is very important to ensure that it complies with all applicable securities laws and regulations.
[Also Read: Debenture Conversion Agreement]
Pros and Cons of Convertible Note
Advantages:
- It is easier to structure since more detailed provisions, as in other corporate documents, are not required. Therefore, convertible note financing offers a faster and easier mode of funding for companies, especially startups.
- Because it is easy to structure and avoids drafting lengthy documents, the legal cost of issuing a note is significantly lower than, say, issuing shares.
- It allows the company to delay its valuation to a later date. This is helpful for companies that are in the early stage and have not had enough time to increase revenues.
- The investors stand to gain by way of valuation cap and conversion discounts.
Disadvantages:
- If too much debt is taken in the form of these notes, it will place a burden on the company during the conversion period.
- If the note automatically converts to equity during the subsequent issue of shares, the investors may have to forcefully acquire shares regardless of whether they are satisfied with the terms of the subsequent issue or not. This places them in a position of low bargaining power as far as subsequent equity financing rounds are concerned.