To grow your business, you may need to bring in investors. Investors will provide money to your business in exchange for some sort of return. They will usually offer money as either debt or equity. Debt means that the business must pay the money back to the investor along with any interest accrued during this time. Equity means that an investor receives shares in the company in exchange for their capital contribution. A convertible note is a hybrid equity debt instrument as it acts as a loan until the maturity date when it converts into equity. A convertible note term sheet outlines the key commercial terms of the convertible note you issue. This article will explain what due diligence you should undertake when entering into a convertible note term sheet with your investor.
Capital raising is a critical time for any startup. Take control of your startup’s equity with this free cap table template. It will also allow you to analyse and compare financing rounds to make the best capital raising decisions.
What is Due Diligence?
Due diligence is a process that most businesses go through when undertaking a transaction. Due diligence is an investigation into a transaction to verify facts before confirming. It allows the party to verify what the other party has said and whether the transaction is in their best interests. It is often conducted with the help of advisers such as lawyers and investment banks.
What is a Convertible Note?
A convertible note is a type of security that helps a business raise money. In the short term, it acts like a loan, with the business having to pay interest on that loan. However, instead of paying back the principal at the maturity date, the investor will receive shares in the business. Convertible notes are popular as investors can protect their downside through regular interest payments. They also benefit the business as they do not need to repay the principal in cash.
Continue reading this article below the formWhat is a Convertible Note Term Sheet?
A convertible note term sheet is a legal document that an investor and a company may enter into before entering into formal documentation regarding the issue of convertible notes. The convertible note term sheet will contain the key commercial details of the convertible note.
What Due Diligence Should I Undertake?
Financial Due Diligence
You should always ensure that a convertible note makes sense for your business. Financial due diligence involves looking at your business’s financial position and deciding whether you need the cash injection and have enough cash flow to cover your interest payments.
Investor Due Diligence
Given that the investor will ultimately become a shareholder of your company, you should consider the following:
- how they operate;
- their business philosophy; and
- whether they represent a good partner for your business going forward.
Timing of Maturity Date
Another vital aspect to consider is the timing of the maturity date. The maturity date is when the convertible note matures. At that time, the investor can often elect whether the principal will be repaid or converted into equity. Most convertible note term sheets will include an automatic equity conversion trigger event (such as a priced equity round) to remove the optionality.
Confidentiality Clause
You must include a confidentiality clause in your convertible note term sheet. This is so your investor cannot divulge any intellectual property or information about your business to another party. Any breach of this clause will mean that you can seek compensation in court for any loss due to the breach.
Key Takeaways
As a business owner, you will likely receive various forms of investment. These investments help grow a business and pay for expenses. A common type of investment is a convertible note. This allows an investor to receive equity at a future point whilst the note acts as a loan in the short term. A convertible note terms sheet contains all the information relevant to a convertible note and is signed by both the investor and the business. You must do your due diligence when reviewing a convertible note term sheet so that there are no surprises in the future.
If you need help with convertible notes, our experienced corporate 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 0800 005 570 or visit our membership page.
Frequently Asked Questions
There is no legal requirement to conduct due diligence, but ensuring there are no issues with the convertible note arrangement in the future is crucial.
You will negotiate this with your investor and can include it in the term sheet.
We appreciate your feedback – your submission has been successfully received.
