Private Equity Financing: The Convertible Note

The Convertible Note is often used by companies seeking private equity financing. The reason the Convertible Note is well-received by investors is that it provides the opportunity to lend funds at a favorable interest rate for the lender, while providing the lender the option to participate in any increase in the value of the equity of the issuer.  From the issuers standpoint, it can be a good method of attracting financing from investors who are uncertain about taking equity in a company from the outset.  This post explores some of the common provisions of a Convertible Note, but recognize that the issuer may have a very different set of expectations than the lender/investor with respect to some very important terms, and this will require negotiation or simply acquiescence by an issuer who requires the financing.

Consider the Convertible Note as having two major aspects (a) the Promissory Note itself under which the funds are loaned to the company and (b) the Equity Purchase and related rights of the investor upon becoming an equity holder.

I.  The Promissory Note

Of course, a Convertible Note includes the terms of a promissory note, and therefore should cover the following financial and business terms.

      1. Loan Principal Amount/Advances:  How much is the principal amount of the loan and, when and under what terms are loan advances to be made to the company?  Often, the investor will opt for a series of advances based on achieving defined milestones (as opposed to one lump sum payment).

      2. Interest rate/when payable:  What is the applicable interest rate and when is it payable?  The rate can be paid on a defined schedule or can accrue and be payable at the end of the term or upon a triggering event (such as sale of the business, obtaining additional financing).

      3. Term of the Loan/prepayment:  What is the term of the loan?  Simply put, the term defines when the principal must be repaid.  In addition, the company will want a right of prepayment, and the investor may want an additional fee in the event of prepayment.

     4. Is it a secured loan?   The lender may require a security interest in all or some of the assets of the company.

     5. Default Provisions/Remedies.  What triggers a default/right to repayment and what are the remedies upon default?  Obviously, the failure to repay the loan, bankruptcy, dissolution and similar events should be grounds for a default, but lender may demand other triggers like, merger or sale of all or substantially all of the assets or stock of the business.  In addition, the Note, especially if a secured note, will include the various remedies available to the lender upon a default, including sale of the collateral.

II. Equity Purchase and Related Rights.

    6. Conversion Trigger.  When is the note convertible?  The Convertible Note will define what event(s) trigger the investor's right to demand conversion.  There may be optional and/or mandatory conversion events, depending on what the parties negotiate.  Also, if I represent the company, I will try to get an option to pay the loan within a certain time following an exercise by the Lender of the conversion right -- if the company is in the financial position, it may prefer to pay the loan (even with a fee) to avoid dilution resulting from the issuance of shares to the lender.

    7. Conversion Formula.  How much equity is issued upon conversion?  The parties must agree on a conversion formula which determines how many shares the lender receives in exchange for the outstanding principal (and perhaps the interest, if agreed). The conversion formula can be one of the most contentious issues as it invokes the need to explore valuation of the company.    

    8. Equity. What class of equity will the loan convert into?  The parties need to set forth the type of stock the lender will receive upon conversion:  common stock, preferred stock and any class thereof.
  
    9. Equity Rights.  What will be the rights associated with the shares received upon conversion?  Some of the common rights a potential equity holder may demand include, liquidation preference, voting rights, dividend rights, anti-dilution protections, right of first refusal, tag along, registration rights, information rights, a board seat, and redemption rights.  As the company, be prepared for a list of demands from the lender.

   10. Additional Covenants.  When representing a lender I may negotiate for a number of covenants that the issuer must observe, including right to approve budgets, management salary, and extraordinary transactions, to name a few.
 
The Convertible Note is a common financing method for companies, but the company (especially early-stage issuers) will have to try to balance the need for the funds versus the desire to avoid relinquishing  substantial financial and ownership rights in exchange for the convertible loan.

Disclaimer:  The discussions in this blog do not constitute legal advise nor create any attorney-client relationship.  You are urged to seek the advice of an experienced lawyer who can provide counsel with respect to your corporate/business law matters.