Convertible Promissory Notes: What Startups Should Know

convertible promissory note

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.

Maturity DateHow 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 InterestHow 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 ClauseIf 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.
Conversion TermsThere 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 ControlThe 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 miles@mwlegalgroup.com to explore your options and let us know how we can help you.

Small Business Checklist Series: Colorado Corporation vs LLC

corporation-llc-business entity-comparison

Introduction: Is your Colorado business better suited in an LLC or a Corporation?

The following is a brief comparison of a Colorado corporation vs an LLC with a few pros and cons of each and which entity structure might be better under certain circumstances. Not discussed here are entities such as sole proprietorships, limited or general partnerships, or the differences between c-corps and s-corps. Also, when discussing corporations, this article refers to c-corps. 

Basic comparison of corporations vs LLCs

 

Corporation

LLC

Organization

File articles of incorporation with the secretary of state. Must file a periodic report each year

File articles of organization with the secretary of state. Must file a periodic report each year.

Governing Documents

By-laws: Contains some material provisions such as appointment of directors but corporations are governed primarily by the Colorado Corporations and Associations Act

Operating agreement: Agreement/contract between members of the LLC

Form of Equity

Shareholders of a corporation hold stock. There can be multiple classes of stock with different rights and preferences. Transferability of shares can be restricted through shareholder agreements

Members hold membership interests which can be assigned or transferred by a member in whole or in part

Liability

Shareholder’s liability is limited to the amount of capital contributed for the shares

Members are only liable up to the amount of capital contributed for the membership interests

Employee Incentives

Stock options and restricted stock can be granted to employees

Employees can be granted profits interests

Capitalization

Raise capital by issuing shares according to the number of authorized shares. The number of authorized shares can be increased by amending the articles of incorporation

Raise capital by issuing membership interests. Unless restricted by the operating agreement, there is not a limit to how much equity an LLC can issue

What are the goals of the business?

It is important to understand the goals of the business as this will heavily influence choosing between a corporation vs an LLC. Questions to ask include:

  1. Is there an exit plan for the business and what is it?
  2. Who will be investing in the business?
  3. How will the business be capitalized?
  4. Do the owners expect the company to grow and be sold or will they likely continue to operate it themselves?

Pros and cons of corporations and LLCs

Corporation

Pros

Cons

Investors such as venture capital firms are familiar with the corporate form and are more likely to invest if that is the goal

Must follow corporate formalities

Ability to grant stock options to employees which are well known

Double taxation (corporate tax + distribution tax)

Multiple classes of stock easy to issue and navigate

Less flexibility than an LLC

LLC

Pros

Cons

More flexibility in structuring the business through an operating agreement

Investors are less likely to invest in an LLC because of less familiarity

Pass through taxation

Employee incentives in the form of profits interests which can get complicated

Takeaways

When deciding to use a corporation vs an LLC, the classic lawyer answer is: it depends. If the business is looking to raise capital early on from outside investors and potentially make an exit one day (thinking start-up), then the corporation is the better option. However, if the business is more of a mom and pop shop that is not looking for venture capital investment, then an LLC offers flexibility and good tax benefits.

Please reach out to Miles Williams at miles@mwlegalgroup.com with any questions regarding your business and take a look at our services!