A convertible note is a loan that can be converted into shares. This article explains how they work and when they are used.
What is a convertible note?
A convertible note is created through an agreement between a company and an investor whereby:
- the investor agrees to loan money to the company, and
- the investor has the option to convert the loan into shares in the circumstances permitted by the convertible note agreement.
A convertible note is not equity. It is a debt instrument that may be converted into shares if the conditions for conversion in the convertible note agreement are satisfied.
When can a convertible note be converted into shares?
The time or circumstances in which a convertible note can be converted into shares will be set out in the convertible note agreement. Examples of typical conversion events include:
- the conclusion of a successful fundraising round,
- the sale of the company or an IPO,
- the achievement of agreed performance targets, and
- a specific date (known as the 'maturity date') having passed.
Some convertible notes will allow the noteholder to convert the note into shares at any time, usually on the basis that the company's shares will be valued at the time of conversion by applying an agreed formula or by reference to a valuation obtained by an independent third party.
When are convertible notes used?
Convertible notes are normally used when it is difficult to value the company's shares (for example, where an investor is seeking to invest in an early stage tech start-up).
Unlike shares, a convertible note can be issued without the parties having to reach agreement on the share price. More specifically:
- If the company wishes to raise money by issuing shares, the parties will need to agree on a share price before they can enter a share subscription agreement.
- For a convertible note, the parties merely need to agree on a mechanism for working out how the share price will be determined at the time of conversion. There is no need to agree on a specific share price upfront.
Often the conversion price will be expressed by reference to a share price used for the purpose of a later transaction. For example, the conversion price might be 80% of the share price used by the company for a subsequent fundraising round or for the purposes of a share sale. It is not uncommon for an investor to seek to put a cap on the conversion price.
How do convertible note agreements work?
The basic mechanics of a convertible note agreement are as follows:
- The investor agrees to advance a specific amount of money to the company, by way of loan.
- The loan would normally bear interest.
- The company is required to repay the loan and all accrued interest by a particular time.
- The investor has the right to convert the loan into shares upon the occurrence of an agreed event or milestone (see above).
- The agreement will explain how the conversion price will be calculated.
- If the investor does not elect to convert the loan into shares, the company will remain liable to repay the loan.
Because a convertible note agreement is simply a contract between the company and the investor, the parties are able to tailor the arrangement as they see fit.
What are the benefits of a convertible note for an investor?
The main benefit of a convertible note is that it significantly reduces the risk of the investor subscribing for shares at an over-value. This is because the value of the company's shares is not required to be determined until a later point in time, and can potentially be pegged to a share price used for a separate transaction.
Another benefit is that, if the company is wound up, the loan will need to be paid out before any distribution can be made to the company's shareholders. However, whether this is actually a benefit will depend on the financial position of the company. If the company has no assets to repay the loan, the investor will not be paid out and will be in effectively the same position that they would have been in, had they been a shareholder.
Can the company's obligations under a convertible note be secured?
Yes, however it is more normal for convertible notes to be unsecured. This is for two reasons.
First, as far as risk is concerned, companies tend to view noteholders in the same way as shareholders. Shareholders do not hold any security over their investment, with the consequence that they are directly exposed to the risk of the company's failure. Companies typically expect noteholders to accept the same level of risk.
Second, unless the security can be enforced independently of the company (such as under a personal guarantee or a mortgage over real estate owned by a third party, both of which are rarely offered up), any security offered by the company will only be as valuable as the company itself. If the company has no assets that can be converted into money in a liquidation, the security would be worthless. Conversely, if the company does have assets, a security interest over the company may provide some priority over other creditors in the event the company is wound up.
What are the disadvantages of a convertible note for an investor?
The main disadvantage of a convertible note is that, prior to conversion, the investor will not have the same rights as other shareholders. For example, the investor will not have any voting rights. For this reason, informed investors will often seek to incorporate specific protections into the convertible note agreement, such as:
- obligations on the company to provide regular reports and to notify the noteholder of any significant events or opportunities that may affect the company;
- the right to appoint a director or an observer to attend board meetings; and
- the right to participate in future fundraising rounds, as if the noteholder was a shareholder.
Is there a standard convertible note agreement?
Unfortunately not. Although many convertible note agreements share common features (as summarised above), they are inevitably tailored to suit the circumstances of the specific transaction concerned.