{"id":2680,"date":"2022-03-16T00:31:15","date_gmt":"2022-03-16T00:31:15","guid":{"rendered":"https:\/\/uk.legalvision.com.au\/?p=2680"},"modified":"2025-07-02T00:41:42","modified_gmt":"2025-07-01T23:41:42","slug":"convertible-notes-convert","status":"publish","type":"post","link":"https:\/\/legalvision.co.uk\/corporations\/convertible-notes-convert\/","title":{"rendered":"What Happens When Convertible Notes Convert in England and Wales?"},"content":{"rendered":"

Do you own a company, and are you looking to raise additional funding to finance a new project? You may have heard about convertible notes in the context of start-up (or seed) financing and are wondering how it differs from debt or equity financing. This article will explain the function of convertible notes and how they compare to debt and equity financing. It will then explain some legal and practical implications you should consider before issuing convertible notes.<\/span><\/p>\n

Overview<\/span><\/h2>\n

Debt vs Equity<\/h3>\n

There are two ways you can finance your company. One way is through the issuance of debt. This is a contractual arrangement between the lender (such as a bank) and a borrower (i.e. your company). The agreement states that your company receives money in exchange for the promise to pay the sum back at some point, plus whatever the interest amount is. <\/span><\/p>\n

The other method is equity financing. An investor (either a professional investor or a friend or family member) gives your company a sum of money in exchange for shares in the company, which entitles your investor to certain rights in the company. These rights typically include the right to share in the company’s profits through dividend payments and vote on shareholder matters. <\/span><\/p>\n

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It is possible to issue a pure debt instrument, for instance, by way of a loan. Likewise, pure equity financing is where an investor gives a company cash in exchange for shares. However, in practice, early-stage companies raising their first institutional financing round will usually do so through hybrid financing. Hybrid financing refers to certain financing instruments with both debt and equity qualities. <\/span><\/p>\n<\/div>\n

Convertible Notes <\/h3>\n

Convertible notes (also called convertible bonds) are a form of hybrid financing that startups commonly use in early financing rounds. In addition, they are commonly used by professional investors such as angel investors and venture capital funds. <\/span><\/p>\n

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If you issue convertible notes in your business, the basic premise is that the investor will lend your company money. <\/span><\/p>\n<\/div>\n

Where it differs from a traditional loan is that the terms of the loan agreement will contain a provision that entitles the investor to convert the loan amount to equity, rather than demanding your company pay the amount back at a later date. <\/span><\/p>\n

There will be certain conditions that the investor (note holder) will have to meet to convert the debt to equity. Usually, this will be after a certain period of time. However, it can also be the occurrence of some specific event. Some examples are if your company meets a key profitability metric or successfully holds its first-stage equity financing. <\/span><\/p>\n

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Notably, the note holder does not have to convert the amount to equity. Even if the condition to convert the debt to equity is met, the noteholder can demand the loan amount back. <\/span><\/p>\n<\/div>\n

What Happens When Convertible Notes Convert?<\/span><\/h2>\n

The answer depends on how you draft the terms of the convertible note.<\/span><\/p>\n

Assuming your company has the authority to issue convertible notes, your company will receive a loan amount upon issuing convertible notes to investors. <\/span><\/p>\n

Depending on if your company has any other kinds of loans on its balance sheet, such as a bank overdraft or revolving credit facility, this loan amount will often be senior unsecured. Therefore, if your company ends up insolvent, the investors will have to wait in line for the secured lenders like the bank to recover their money from your company’s assets. However, they will rank above the equity holders (i.e. the shareholders). <\/span><\/p>\n

The notes will then specify how they will repay the loan and at what interest rate. <\/span><\/p>\n

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You must observe the terms of the convertible note agreement. If you do not, you will default, and the effect will be similar to defaulting on a traditional loan. <\/span><\/p>\n<\/div>\n

Once the condition has been met, the noteholders must notify your company of their intention to exercise this right. If they do, your company must issue them a number of shares corresponding to the loan’s principal amount. This will be based on your company’s valuation. <\/span><\/p>\n

At this point, your company’s noteholders will become shareholders in your company. <\/span><\/p>\n

You will then reduce the amount of loan capital on your company’s balance sheet by the principal amount of the loan. Likewise, you will increase the amount of equity capital by the same amount to reflect the conversion. <\/span><\/p>\n\n\n Continue reading this article below the form\n <\/i>\n<\/a>\n

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