Convertible note financing issues

Critical Issues in Convertible Note Financing

By J. Dain Dulaney, Jr.

Discount Percentages and Automatic Conversions

You have made the decision; you are going to raise money for your new venture by using a convertible note. Given the stage of your company, you made this decision to avoid negotiation over your company’s valuation and to have simpler documentation than a straight equity raise would require.

Now that you have made this determination, there are still a few issues you need to address to help finalize the convertible note documentation. That convertible note documentation will consist of two main documents: a Note Purchase Agreement and a Convertible Promissory Note.

Note Purchase Agreement

The Note Purchase Agreement contains high level terms and basic company representations (e.g., the company owns the intellectual property it uses in the business and, if you have revenue, a current set of your financials). To satisfy security laws requirements, it also contains representations by the convertible note holders, especially that they are “accredited investors.” Attached to this Note Purchase Agreement will be the form Convertible Promissory Note.

Convertible Promissory Note Issues

The Convertible Promissory Note contains critical terms and issues you will need to address in a convertible note financing round. Three of the most important issues are as follows:

Issue #1: The Interest Rate
As I mention in my blog, “Interest”ing Point About Convertible Notes, the interest rate of your convertible promissory note can have a dramatic impact on the final percentage of ownership a convertible note holder receives when the convertible note converts. For that reason you need to carefully consider this issue when determining the interest rate to offer for the convertible note. Be sure to read my blog for more information on this issue, available here.

Issue #2: Percentage Discount on Automatic Conversion
One of the main features of a convertible note is an automatic conversion of the amounts due under the convertible note into equity (most likely preferred stock), if the company raises a predetermined amount of money from later investors in the future. The rationale behind an automatic conversion is that the company will be at a later stage and those later investors will be in a better position to place a valuation on the company and that valuation will be reflected in the price per share of the preferred stock they receive in exchange for their investment as agreed upon by the later investors and the company.

Upon that later investment, the convertible note holders will then automatically have their principal and interest due at that time converted into shares of the preferred stock issued in the later financing round.

The first step in the calculation of how much preferred stock the convertible note holders will receive is to apply a discount percentage to the price per share of preferred stock received by the later investors. The accepted standard for this discount rate is 20% but I have seen as little as 10% and as much as 30%. The larger the discount percentage the more favorable for the convertible note holders.

The next step is to determine the number of shares of preferred stock to be received by dividing the principal and interest due on the convertible note (the “Balance”) by the discounted price per share of preferred stock to determine the number of shares of preferred stock the convertible note holders will receive.

Let’s use an example to illustrate. Assume (a) the price per share of preferred stock in the later financing round is $1, (b) the convertible note holders receive a discount of 20% off that new price per share of preferred stock and (c) the Balance is $100,000. The price per share of preferred stock to be used for the conversion calculation would be $0.80 (a 20% discount to the $1 per share of preferred stock price). The number of shares of preferred stock to be received by the convertible note holders would be determined by dividing the Balance by $0.80, so that the convertible note investor receives $100,000/$0.80 = 125,000 shares of preferred stock.

This is at least 20% more than the 100,000 shares of preferred stock the later investor would receive for that same $100,000 at $1 per share of preferred stock (and is actually greater since the convertible note holder also received credit for interest on the amount they invested).

Issue #3: Caps on Conversion Amounts
The company’s valuation, for purpose of the conversion, may have a cap and this is an issue I will address in later blogs.

Cautionary Notes

1. Watch for Notes Where Conversion is Not Automatic but at the Investor’s Option

I have seen documents titled “Convertible Notes” offered to companies by certain investors where the convertible note holder is not forced to automatically convert to equity but retains an option to convert their Balance into equity.

Since most investors view convertible notes more like equity than a loan, this is an unusual approach. Because the convertible note holder may never convert their Balance into equity, companies should view these not as “Convertible Notes” but simply loans to the company, which the company will need to repay, with interest, when the “Convertible Note” becomes due (usually 1-3 years in the future).

One of my clients agreed to a “Convertible Note” with these terms but only after deciding that if it needed to repay the “Convertible Note” in the future, it would try to raise more money to repay it. This ended up being good planning because the convertible note holder’s circumstances changed over time and the convertible note holder did not exercise the option to convert the “Convertible Note” and my client was put in a position of having to raise additional capital to repay the Balance, which it was fortunately able to do.

2. Granting Security Interests Can Turn into “Foreclosure”

Sometimes these “Convertible Notes” also include terms that give the convertible note holder a “security interest” on all of the company’s assets.

This is like a mortgage house. If the convertible note holder chooses not to convert the “Convertible Note” and the company is unable to pay the Balance back when the “Convertible Note” is due, then the convertible note holder can start a proceeding, not unlike a house foreclosure, that allows the convertible note holder to sell or take over the company’s assets.

I believe giving an early stage investor this type of power is bad for the company and should be avoided.

In summary, consider the discount percentage that you offer investors in conjunction with the interest rate and decide whether you need to increase the standard 20% to attract investors or whether you can reduce it because the company is doing well.

Also, be wary of investors offering “Convertible Notes” where they only have the option to convert, especially if the “Convertible Note” also gives the convertible note holder a security interest in all of the company’s assets.

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