There are several ways that startups raise capital. One way is to issue convertible notes in exchange for investors loaning the company funds. Convertible bonds behave like equity and debt. Until the notes convert, the company must repay the convertible notes like any other debt. However, when the option to convert arises, the noteholders may swap the repayment obligations for equity in the company. This article will outline the process of converting convertible notes. It will also detail some important legal and commercial implications.
Convertible Notes on the Cap Table
Convertible notes convert into shares (or be subject to repayment by the company) at predetermined trigger events. These trigger events are usually:
- the maturity date (when the loan amount must be repaid or converted if another trigger event has not occurred);
- a ‘qualifying financing’ (where the company raises a round of equity investment through the issue of shares to investors); or
- an ‘exit event’ (where a company sells its shares and assets or lists on a stock exchange).
When using convertible notes, your investors do not receive shares upfront. They are therefore noteholders rather than shareholders. In other words, they are creditors. However, they will receive shares if their convertible notes convert. Therefore, it is important to carefully consider the effect of convertible notes on your company’s cap table.
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Further Considerations
You should also note that your convertible notes may attract interest. If this is the case, the amount that will convert is generally not just the original loan amount, but with interest added on.
For example, when you are considering undertaking a qualifying financing, you will need to prepare a capitalisation table that shows what the company’s share structure will look like after the qualifying financing is complete. In this capitalisation table, it is important to show the:
- new investors being issued shares as part of the qualifying financing; and
- shares which will be issued to your noteholders upon conversion of their convertible notes.
This allows you to show the potential effect of the noteholder’s conversions on the existing shareholders’ portion of ownership. In turn, this may affect how much of the company you are willing to part with in your qualifying financing. Your new investors will also want to understand the effect of noteholder conversions as this impacts how much of the company they will own after the qualifying financing is complete.
Conversion at the Maturity Date
If a qualifying financing or exit event does not occur before the maturity date, at the date the notes mature, the holder can choose to:
- recover their loan amount (plus interest); or
- convert their loan amount (plus interest) into shares.
If the noteholder does not make a choice within the required time frame after the maturity date, the convertible note terms will usually outline a default provision. Typically, this result is that the loan amount (plus interest) will convert to shares.
If the convertible notes convert into shares, the company will need to determine how many shares to issue to the noteholder. To do so, the company will usually divide the loan amount, plus any accrued interest, by a certain share price. The note documentation will specify how this price is calculated.
You will also need to determine the class of shares to issue to the noteholder. Conversion at the maturity date will usually require the company to issue the noteholder with the highest class of shares on issue at the time. These are usually preference shares which give investors a preferential right to receive distributions in the case of a liquidation event.
While it is uncommon for investors to enforce recovering their loan amount (plus interest) and potentially winding up the company at the end of the required timeframe, you may have to re-negotiate financing terms with your investors.
Continue reading this article below the formConversion at a Qualifying Financing
If there is a qualifying financing, usually convertible notes will automatically convert into shares. The terms of your convertible notes may require you to give your noteholders written notice, often referred to as a ‘conversion notice’. This notice states the company’s intention to issue the noteholder with shares as a result of the qualifying financing. The conversion notice should also set out:
- the number of shares to be issued to the noteholder; and
- how the company calculates that number of shares.
However, if the convertible notes include a valuation cap, the share price used for the conversion could be determined by reference to the valuation cap. If this results in a lower share price than the share price in the qualifying round this will result in a further discount for the investor.
For conversion at a qualifying financing, the terms of the convertible notes will usually require the company to issue to the noteholder the class of shares it issues as part of the qualifying financing. As noted previously, these are usually preference shares, or seed preference shares.
Conversion at an Exit Event
The terms of your convertible notes will usually require the company to notify the noteholder prior to entering into documents to give effect to an exit event. Usually, the noteholder can choose whether they want to:
- recover their loan amount (plus any interest) in cash; or
- convert that amount into shares.
For conversion at an exit event, the company will issue ordinary shares to the noteholder. This means that the noteholder is treated like any other ordinary shareholder as part of the exit event.
Procedural Considerations
When your convertible notes convert, the company will need to undertake a number of steps in order to issue shares to the noteholder. A lawyer can advise on the procedure for issuing shares under a convertible note issuance.
Key Takeaways
If you are raising capital using convertible notes, you need to consider the consequences of those convertible notes converting. You should understand:
- the trigger events which give rise to conversion (i.e. qualifying financing, exit event or reaching the maturity date);
- how you will calculate the number of shares to issue to the noteholder;
- the effect of any accrued interest on the number of shares issued to the noteholder;
- how the company’s cap table will change following the conversion; and
- what steps the company needs to take to effect the conversion.
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Frequently Asked Questions
Convertible notes is a hybrid form of financing. When the notes are issued, the noteholders are creditors entitled to repayment according to the terms of the notes. However, under certain conditions, the notes may convert to shares in the company depending on the terms of the notes.
Either the company, the noteholders, or both parties may elect to convert the notes under certain conditions. These commonly include: at the point of maturity; when the company hits a valuation milestone; or when the company undergoes another round of financing.
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