What Are They?
Convertible promissory notes are a form of debt that a company can issue to raise money. The person or entity providing the capital in exchange for the note is called the noteholder. Essentially, it is a loan from the noteholder to the company with an interest rate and a maturity date. But unlike a traditional loan, the convertible note can convert into equity of the company upon certain events at specified terms.
Convertible notes are a great way for early-stage companies to raise capital. Convertible notes are less costly for companies to issue as these documents are simpler to draft than private placement documents, for instance. This is often a concern for early-stage companies that do not have large legal budgets. It also saves the company from having to go through the timely and costly activity of valuing itself. It pushes the need to price shares of the company to a later date after the company has grown and is ready to raise more money. In the meantime, issuing convertible notes only requires negotiating the terms of the notes themselves. Noteholders also have less rights when investing in convertible notes, unlike equity. This shortens both the due diligence process and the negotiation process.
What Terms Should a Startup Be Aware Of?
When negotiating a convertible note, there are several terms that the company should be aware of. The company’s long-term goals will matter in determining how the terms of a note will affect the company later.
|How long is the term of the note and what happens at the maturity date? The company should consider what would happen if the noteholder chose not to convert into equity and if the company would be able to repay principal and interest.
|Simple vs Compound Interest
|How does the interest accrue and what is the interest rate? An interest rate that is too high or even a compound interest term may be a burden on the company and the noteholder’s interests may not be aligned with those of the company.
|Most Favored Nations Clause
|If the company issues other notes to different investors, the company may be required to amend the terms of the first convertible note to match the terms of subsequent convertible notes if they are more favorable.
|There are many details that determine when and how the noteholder may convert into equity of the company. Issues to look for here are whether there is a discount for the noteholder on equity, how much equity must a company sell to constitute a financing, and whether the convertible note is included in that amount.
|Change of Control
|The company should consider what happens to the convertible note if the company does not raise more money in the future but instead, sells the company. Does the noteholder still get to convert? If so, on what terms?
Some terms in a convertible promissory note are more negotiable than others. As always, it depends on a company’s leverage and experience dealing with such notes. MW Legal Group can go to bat for your company when negotiating debt or equity instruments. We realize that creating a synergy between the company and its investor is crucial to reaching a successful transaction and use our knowledge and skill to help companies achieve their goals. Reach out to Miles Williams at email@example.com to explore your options and let us know how we can help you.