Table of Contents
In Short
- Understand how convertible notes convert into equity during funding rounds or specified events.
- Learn the implications of conversion terms on shareholding and startup valuation.
- Discover the importance of preparing for potential dilution and investor impact.
Tips for Businesses
When negotiating convertible notes, pay close attention to the conversion terms to ensure they align with your startup’s growth strategy. It is crucial to plan ahead for potential shareholding dilution when these notes convert to equity. Engage with legal and financial advisors to optimise your funding strategy effectively.
If you are thinking of financing your startup company, you may have come across convertible notes. Convertible notes are an excellent way of raising money at the early stages of your business without needing to pay coupons. Knowing what will happen when the convertible note converts and the noteholders get their equity share in your business is essential.
This article will explain what happens when a convertible note converts, and will also touch on broader points to keep in mind as the issuer of convertible notes.
What is a Convertible Note?
Put simply, a convertible note is a debt instrument used to raise money, usually for early-stage companies. A convertible note differs from a standard note. Instead of materialising into a payment of the principal at its maturity date, the convertible note converts into an equity share (in the form of preferred stock) in your company. This means that you will usually not be obliged to pay interest, coupon payments, or the principal sum at the maturity date while the noteholder has the note.
Convertible notes usually convert subject to certain conditions. The conditions under which the convertible note converts will influence exactly what happens. Thus, it is essential to familiarise yourself with the conditions you agreed upon as part of your note issuance.
When Will It Convert?
A convertible note, as mentioned, will convert subject to certain conditions. Those conditions, sometimes known as trigger events, vary depending on the terms of the note. Some common trigger events are:
- the maturity date;
- an exit event; or
- a qualified financing.
In essence, an exit event is usually where a company lists on a stock exchange or sells its assets and shares. A qualified financing is when the company issues shares to other shareholders to raise equity. In those situations, the note may automatically convert into a share. However, if these conditions do not happen, the note will convert on the maturity date.
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What Happens on the Maturity Date?
If your startup company does not go through a qualifying equity financing period or has no exit event, the shares will usually convert on the maturity date. Usually, this means that the noteholder will have the choice to:
- recover their initial loan amount as part of the note agreement with the issuing company; or
- convert their initial loan amount into shares in the issuing company.
Further, as the issuing company, you may also need to decide what type of shares convertible noteholders will receive. Typically, convertible noteholders will want preferred stock over common stock. This is because preferred stock is prioritised when the company’s money is divided. Therefore, issuing preferred stock is usually a good way of getting investors to put money into an early-stage company. In addition, it allows them to slightly hedge against the risk of default by the issuing company.
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Conversion in Other Ways
As mentioned, conversion may also occur due to trigger events such as qualified financing or an exit event.
In the case of both qualified financing and an exit, the convertible notes will automatically convert into shares. This will oblige you to give written notice to the noteholder that their notes have converted into shares. It may also require you to outline how you will calculate the number of shares they will receive.
Key Takeaways
A convertible note will usually convert when certain conditions have been met or when the maturity date has come. Consequently, your business must take specific steps, such as notifying noteholders and calculating the number of shares to be issued. This will usually be in the form of preferred stock, and the valuation of your share price will likely be stable by the time a conversion event occurs.
Making sure that you deal with your obligations promptly is a good way of incentivising potential investors in the future and will be crucial for your growth in the long term.
If you need help with convertible notes, our experienced startup 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 on 0808 196 8584 or visit our membership page.
Frequently Asked Questions
A note is a debt instrument where the issuing company agrees to coupon payments, interest and principal payments at the maturity date in exchange for money from the noteholder.
A convertible note is a note that converts into a share when a certain event occurs.
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