If the convertible note has not converted prior to the end of its term due a financing or sale of the company, the best option is usually to extend the term of the note for an additional year.
Investors commonly use convertible notes to invest in startups because they are inexpensive and quick to draft. The investor or company produces the form of note and the parties have a closing, or multiple closings, at which signing and funding occurs.
The convertible note, however, is not easy to read and its implications are sometimes not fully understood by the company.
- A convertible note combines debt – the investor loaning money to the company – and an option – the right of the investor to convert the debt to equity in certain circumstances.
- The convertible note’s purpose is to defer the expense and complexity of drafting preferred stock until a seed or A round, at which time the note automatically converts to preferred stock in the round based on the conversion formula in the note.
- The company should monitor the potential dilutive effect of the note on conversion, based on the valuation cap in the note and interest accrual.
What happens, however, if the note matures before a priced round occurs?
- Most convertible notes, like other forms of debt, provide that they are due at the maturity date, usually 18 to 24 months. Occasionally, convertible notes will provide that at maturity they automatically convert to equity, or convert to equity at the option of the lender.
- The purpose of the promissory note is to allow the investor to convert to preferred stock later at a favorable valuation based on the cap, and therefore it makes sense for the investor and the company to agree to extend the term of the note to allow more time for the preferred financing to take place.
- In this scenario the company has leverage because
- the company is providing more time for the investor to realize a gain in a future financing
- the investor effectively has no recourse against the startup if the investor forecloses because there are unlikely to be significant assets to satisfy any judgment and the investor would spend money out-of-pocket in an enforcement action
- the investor’s reputation in the startup community would likely be adversely impacted if the investor takes legal action against the startup
- Trying to avoid the problem by providing that the note automatically, or at the lender’s option, converts to preferred stock at maturity is usually not a good idea. This would require the investor and the company to determine the terms of the preferred stock to be issued at maturity when the note is being negotiated. If that is the case, the advantages of the note – quickness and simplicity – are lost and the parties may as well have issued the preferred stock in the first place.
If you require any further information about Convertible Notes or startup investments, please contact Edward Grenville, Managing Shareholder, Inspire Business Law Group, PC (egrenville@inspirelawgroup.com; +415 279 0779; www.inspirelawgroup.com).
This article is provided for educational and informational purposes only and is not intended to be, and should not be construed as, legal advice.