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What is a convertible promissory note in simple terms?
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In this article, I will break down the legal meaning of a Convertible Promissory Note so you know all there is to know about it!
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What Is A Convertible Promissory Note
When a business needs to raise capital to start or grow its new venture, there are many routes it can take.
Most commonly, companies tap into debt, equity, or a combination of the two.
The convertible promissory note is a hybrid financing option that combines both debt and equity with consideration for both the short and long term.
This method of raising capital is commonly used by startups and other emerging early-stage companies.
It’s important to know that convertible promissory notes are typically not secured by the business’ assets since the loan is short-term and usually gets converted to shares.
You won’t see established companies issuing convertible promissory notes, as the advantages are in favor of startups.
Read on to learn more about this legal document, including its pros and cons…
How Do Convertible Promissory Notes Work
Unlike a regular promissory note that outlines the terms and conditions of the repayment of a loan, a convertible promissory note involves more.
When a company borrows money under a convertible promissory note, the investor has the additional option to convert the outstanding principal balance into equity at a future date.
The future date is usually marked by the occurrence of a ‘triggering event’, which could include:
- The company attains its capital goals by reaching a pre-specified dollar amount
- The loan matures
- If the company defaults
- The lender requests a conversion for any reason of their choice before the note maturity
- The company is acquired by another investor or company
Let’s say one of the above triggering events occurs, the lender then has the option to be repaid with money or to receive equity in the company.
If the investor holds until maturity, they can decide whether they want to be repaid with cash and interest payments, or convert it to equity as an investment with the hope to gain profits as the company grows.
Convertible Promissory Note Conversion Process
Now that we’ve established a series of triggering events that begin the process of equity conversion, let’s take a closer look at the process.
The moment that the event occurs, the parties must figure out the number of shares that the debt should be converted to.
This is a crucial process that affects the lender and all other shareholders since it is in their best interest to have as little dilution as possible in terms of ownership.
Regardless of the method used for conversation, all of the accrued and unpaid interest is used to calculate the final sum of outstanding debt.
The type of stock must also be decided by the parties, as it can be either common stock or preferred stock.
That said, there are different methods used to calculate the number of shares to be issued.
First, a predetermined price per share that is typically discounted.
This amount is then used to calculate how many shares to issue to the holder, based on the total outstanding debt calculation.
Second, if the company has a recent valuation, the shares can be converted using a specific formula that takes into account the valuation.
Note that the date of the valuation could be on the conversion notice date, the date of the conversion, or another day that the parties agree to.
Third, if the company gets sold, the parties can use a predetermined formula to convert the shares, using the price per share that the buyer proposes (with an additional discount to the lender).
What Is Included In A Convertible Promissory Note
The typical sections of a convertible promissory note include:
- Maturity date
- Interest rate
- Events of default
- Conversion right and process
- Prepayment process
- General provisions
Here are some of the key terms explained in further detail.
Since money is being lent, there’s an interest rate that accrues on the principal amount invested.
Instead of being paid back in cash like a regular loan, the accrued interest functions to increase the equity issued once the conversion takes place.
Is the pre-determined date at which the company must repay.
Early investors who take on additional risk receive a valuation discount to compensate them.
This discount rate encourages early investment.
Convertible Promissory Note Pros
In comparison to other financing options, the convertible promissory note offers privacy and discretion to the borrower.
This note allows a company to raise capital without making a public valuation since the parties can agree to make a valuation estimate of their own.
This is a large advantage for seed-stage companies, as there usually aren’t enough data points in the early stages to form an accurate valuation.
From a legal perspective, convertible promissory notes are a simple and easy process, with a lower cost and quick turnaround time.
They serve as great starting points for initial capital investments, hence their widespread use in the startup world.
Convertible Promissory Note Cons
There are some potential downsides to using this method to raise capital.
First and foremost, there’s the real risk that the company cannot (or chooses not to) raise enough equity.
Although many convertible notes include an automatic provision for the debt to convert to equity at the date of maturity, many don’t.
This is a risk for investors, so it’s important to have a clear path to growth and a backup plan in case of failure.
A risk for companies is that their value may decrease from the date of financing to the actual time they convert the debt into equity.
What this means is that the initial investors may end up owning a larger share of the company than intended.
In addition, investors have higher priority over the business owners in the case of bankruptcy.
This means that in the worst-case scenario, the owners face a high risk.
Finally, since the note must be converted to equity before the date of maturity, investors have the opportunity to ask for full repayment of principal and interest if the conversion hasn’t taken place.
This could cause bankruptcy depending on the financial health of the company.
So there you have it folks!
Convertible promissory notes can be a fast and simple way to generate a first-round investment and get your business moving.
However, there are some risks to both investors and borrowers to keep in mind, although they can be minimized if precautions are taken.
Now that you know what is a convertible promissory note and how it works, good luck with your research!
I hope you enjoyed this article on Convertible Promissory Note! Be sure to check out more articles on my blog. Enjoy!
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