Convertible Notes: Understanding the Debt and Equity Hybrid

Authored by Anthony Bekker and Casper Xiao‍

Convertible notes are a popular means of quickly securing financial investment for early-stage startups. They’re usually “cashed out” at a later stage, be that in an equity round, or a business exit, and can be thought of as a loan that bears interest over time.In this guide to convertible loan notes, we cover:

• What is a loan note?
• Why should you issue convertible notes?
• Legal considerations for convertible notes?
• How to structure a convertible loan note?
• Legal help with convertible notes

What is a loan note?

Convertible notes are a hybrid of debt and equity. It involves an investor making a loan to a startup which converts to equity on a predetermined trigger event (generally, this is the raising of a qualifying round or an exit event). The conversion rate is usually calculated by reference to the share price of the priced round or the exit event.

Why should you issue convertible notes?

Convertible notes have the advantage of allowing you to delay valuing your business. They can also be tailored to have a “valuation cap” (i.e. a maximum price on the note that will convert into equity). Parties can negotiate this valuation cap when raising the round, so you are effectively negotiating a valuation when raising under a note.Startups typically use convertible notes at the seed round stage, although they can also be useful when raising bridging finance between rounds.Convertible notes are also simpler to document and generally have less legal costs to set up as they do not need the various corporate documents to be produced immediately, when compared with equity funding.

Legal considerations and things to watch out for

A convertible loan note agreement may create uncertainty over the final ownership structure once the note matures.In setting valuation caps and a conversion discount, price expectations may be anchored for future equity rounds.Importantly, as debt is regulated, you should ensure you comply with any applicable regulations when dealing with convertible notes.

How to structure a convertible loan note

Next, let's tackle the key components of a convertible note. First up...

Investment and purpose

The company issues ‘notes’ to the investor in exchange for their investment. A note usually has a ‘face value’ of $1. So, an investor who invests $100,000 will receive 100,000 notes. The investor will pay the investment amount when they sign the convertible note.Some convertible notes may also contain a requirement that the company use the investor’s money for a particular purpose. For example, as operational expenses of the company or to develop specific technology. The specific details can be negotiated with the investor.

Interest

Sometimes, the notes will accrue interest from the day they are issued until the day they convert into shares or are repaid. The startup can pay the interest amount to the investor. But more commonly, it will just form part of the investment amount and will convert or be repaid at the same time as the original investment.

Trigger event/conversion events

The main reason investors use convertible notes to invest in a startup is that their investment converts into shares at certain events, most commonly:

• A 'qualifying round' (where the company raises a round of equity investments through the issue of shares to investors) or;
• And 'exit event' (where a company sells its shares and assets or lists on a stock exchange) or;
• The 'maturity date' (when the loan amount must be repaid or converted if another trigger event has not occurred.

Qualifying round

A qualifying round is an equity capital raise where the company issues shares to the investor in return for their money. Typically, for a qualifying round to be a conversion event, it must be of a particular size (e.g. a minimum of $500,000 total investment).

Exit event

An exit event is where the business is sold, and covers a range of different scenarios including:

• an asset sale (i.e. when someone purchases someorall of the company's plant and equipment, land, buildings, machinery, stock, goodwill, contracts, intellectual property, etc),
• a share sale (i.e. when someone purchases the shares in the company); or
• an initial public offering (IPO) (i.e.when the company i publicly liseted for the public to purchase

Maturity

Maturity is a future date by which the investor expects to have either received their shares or had their money paid back. Some convertible notes will specify that the notes automatically convert into shares at maturity, while others will provide an option for either party to decide whether the investment is repaid or converted at a pre-agreed method specified in the convertible note terms.In the event that the notes do not convert into shares under a qualifying round or exit event, it is also the date for which the company must repay the investment account.  Usually, the maturity date is set for a few years in the future, and assumes that another trigger event,  such as an exit event or qualifying round will occur before it.

Conversion price

When a conversion event occurs, the investor receives the number of shares equal to their investment amount (including interest) at a discount. The discount is usually between 10-20%, and together with the investment amount, this is known as the conversion price.A discount gives the investor more shares in the company than they would otherwise have if they purchased shares directly at the current share price. Its purpose is to reward the investor for backing your startup early on. The conversion price is what makes a convertible note attractive for investors.

Valuation cap

Some investors may require the convertible note to include a valuation cap. A valuation cap results in the amount invested converting into equity at a maximum price — even if the value of the company at the next capital raise is higher than that cap. For example, if the valuation cap was $1 million, but the company’s valuation at the qualifying round was $1.2 million, the amount invested would convert into equity at the $1 million valuation cap.Using a convertible note means founders can technically delay valuing the business. At the time you need the funds, you might not have launched a product or gained market traction to help boost your valuation.If your investor purchased shares directly at that time, they could negotiate a lower valuation. This would result in you giving away more of your company than you want. By raising under a convertible note, you’re giving yourself time to build to a more favourable valuation.

Default events

A convertible note will also set out what happens if the investor or the company commits a default event. For example, the investor can call (i.e. ask) on the company to repay the notes if it becomes insolvent. Other possible default events include:

• the company failing to pay their investor outstanding money (e.g. interest); or
• the company making an incorrect or misleading representation in the convertible note.

The convertible note will also specify the status of the notes in the event of a default. Usually, convertible notes will rank before other loans, being a ‘subordinated’ debt, but repayment will nevertheless take priority before equity.

Legal help with convertible notes

Convertible notes can be a valuable tool for startups looking to raise capital, but navigating the legal aspects and understanding whether they are suitable for your company can be complex.In need of corporate law support? Biztech Lawyers is a multi-award-winning law firm, known for fuelling and protecting tech innovation worldwide. Get in touch now to see how we can help.