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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.
Overview
Debt vs Equity
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.
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.
Convertible Notes
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.
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.
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.
What Happens When Convertible Notes Convert?
The answer depends on how you draft the terms of the convertible note.
Assuming your company has the authority to issue convertible notes, your company will receive a loan amount upon issuing convertible notes to investors.
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).
The notes will then specify how they will repay the loan and at what interest rate.
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.
At this point, your company’s noteholders will become shareholders in your company.
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.
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Commercial Considerations
As a business owner, when you issue convertible notes, you should do so under the assumption that the conditions for conversion will be met and the investor will acquire equity in your company.
In this sense, issuing a convertible note will have the same ultimate effect as issuing equity. However, practically, you may not find many professional investors willing to finance your company directly through equity. Convertible notes give your company’s investors the protection of a loan agreement before they convert the note.
However, because the convertible loan agreement gives them the option to convert this amount to equity, the interest on the loan amount is often much lower than you would be able to get at a bank.
Legal Considerations
Convertible notes contain complex legal terms. Therefore, you should not issue convertible notes using standard form documents because the terms may not correspond to your business needs.
You will have to follow specific corporate governance rules before even issuing the notes. For instance, you must ensure your company’s constitution permits you to issue the notes.
Therefore, you should seek the advice of a commercial solicitor before issuing any convertible notes.
Key Takeaways
Convertible notes are commonly used in the early stages of your business’ growth, often after you have raised money from friends and family and made use of business loans available to small businesses. The effect of issuing convertible notes is that your company’s investors will loan an amount to your company, which your company will have to pay back with interest according to a specified schedule. The loan terms will specify certain conditions that, if met, entitle the investors to swap the loan amount to equity. At this point, your company no longer has to repay the loan. Instead, the noteholders will become shareholders.
If you need help navigating your business’ next financing round, our experienced corporate lawyers can assist as part of our LegalVision membership. For a low monthly fee, you will have unlimited access to lawyers to answer your questions and draft and review your documents. Call us today at 0808 196 8584 or visit our membership page.
Frequently Asked Questions
A convertible note is a kind of financing where your company receives a loan from investors. The loan terms will specify certain conditions that, if met, entitle your investors to swap the debt into equity, which would make them shareholders. As you can see, it combines both debt and equity financing elements.
When conditions for converting the notes are met, the investors can exercise their right to convert the notes into equity by notifying your company. You will then issue the investors a number of shares corresponding to the loan amount’s value. They will become shareholders and assume certain rights like receiving dividend payments and voting on shareholder resolutions. As a result, your company will no longer have to pay the loan amount back.
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