The Convertible Note: How It Works, Key Components, Benefits, and Variations

So what are convertible notes and what do you need to know about convertible notes if you are seeking financing for your startup or business?

Convertible notes have been extremely popular lately, especially with tech startups.  Everyone has an opinion on why but in simple terms, the convertible note allows a startup to postpone the valuation problem until a later date while providing certain benefits to the issuing company and protections for the investor.  Convertible notes are especially popular with early stage angel investors as well as friends and family.

What is a convertible note and how does it work?

A convertible note is a hybrid of debt financing and equity financing.  The holder loans the company a specific amount of money and assumes the role of a traditional bond holder.  At some point in the future, a trigger event will occur that converts the note into an equity interest in the company.  The size of the equity interest is based upon the amount of the note, the discount rate, and the company’s valuation at the date of the trigger event.  The trigger event is usually the next round of financing but there may be other triggers including puts or calls.

What are the key components of a convertible note?

Conversion/Discount rate.  Since convertible notes are typically used in early financing rounds there is more risk and more risk equals more reward.  The reward is a discount on the conversion, which will vary by deal.  So if the next financing round issues shares at $1.00 per share and the discount is 20%, then the note holder converts debt to equity at $.80 per share.  Some notes may include a scale that determines the discount rate based on the duration over which the note is held.  So the longer the investor waits for the next financing round, the better the discount rate he receives.

Type of equity interest.  The type of equity interest the debt converts into is also an area subject to negotiation.  Many deals convert the note to preferred stock while others convert to common stock but conversion to common stock can have some unintended side effects.  This is particularly true if common stock is issued at a different price than a recent transaction without a justifiable change in the company’s valuation.

Interest rate.  Interest accrues prior to conversion at a fixed rate, however, unlike straight loans or some preferred stock, the interest is not paid out over the course of the debt.  Instead it accrues with the note and the note holder receives the interest at conversion.

Maturity Date. This is the date at which the debt becomes due and payable (w/ interest) if the note is not converted to equity.  This is effectively a time limit on the company to achieve the growth or potential necessitating the next round of financing while protecting the investor from an endless possibility of not seeing a return on his investment.

Repayment Terms.  The goal is always to reach the next financing round that triggers conversion to equity but that doesn’t always happen.  As such, a note needs to include repayment terms and protections if the note does not convert prior to the maturity date.

Valuation cap.  The valuation cap is an optional although increasingly common clause designed as another incentive to the investor by limiting the company’s valuation at conversion.  Without a valuation cap, a higher valuation at the next financing round lowers the investor’s equity stake.  The valuation cap addresses this issue by limiting the valuation for purposes of determining the equity conversion under the note.  For example, assume 500k note with a 20% discount and a $5mm valuation cap.  If the company’s valuation at the next financing round is $10mm, then the note holder actually receives a 50% discount on his conversion rate.

What are the benefits of using a convertible note?

There are numerous benefits to the company. First, it allows the company to postpone the valuation discussion. It also creates cash flow benefits by minimizing cash interest payments.  Convertible notes are also less expensive and easier to implement than a full equity financing round.

There are also numerous benefits to the investor.   The convertible note protects the investor to a certain degree by initially assuming the role of bond holder.  If the startup fails to reach the next round of financing, the investor as a creditor has a higher priority claim than an equity holder.  And of course, the investor gets the advantage of the discount when acquiring his equity position.

What are some of the variations on the basic convertible note?

Subordinated Convertible Note. This note contains a subordination clause in favor of specified types of senior debt, i.e. bank loans that may be taken out by the company.  One of the advantages for an investor int he convertible note is the status of creditor but there is priority among creditors.  Most banks will not extend credit to a company without an agreement from note holders to subordinate their claims and this clause simply incorporates that requirement into the initial note agreement.

Secured Convertible Note.  This note creates a security interest in collateral owned by the company in addition to the traditional convertible note terms.  The security interest is perfected by filling additional UCC forms with the Secretary of State.  This term is fairly rare but some investors may insist if the investment is particularly risky as it adds specific collateral to bolster the investor’s position as a creditor until the note converts to equity.

 

David B. Willis

David B. Willis

Bryan Willis is a Tyler lawyer providing legal services across Texas in the areas of business law, litigation, probate, and estate planning.
David B. Willis

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