By UpCounsel Corporate Attorney Lauren Roberts

What is a convertible note purchase agreement?

A convertible note purchase agreement is an agreement between certain investors and a company that binds all the investors to the same terms and conditions for a particular round of convertible debt financing. Convertible debt is debt that can be converted into equity. A common trigger for the debt to be converted into equity is the company’s acquisition of a subsequent round of capital (amounting to an agreed upon monetary value).

When do you use a convertible note purchase agreement?

A note purchase agreement is used whenever a company is issuing convertible debt via convertible promissory notes.

Why should you use a convertible note purchase agreement?

A convertible note purchase agreement is one of several documents used in deals where convertible debt is being issued. Convertible debt is a desirable way for companies to raise money for reasons such as:

  • It can postpone the need for a valuation of the company.
  • It can delay the issuance of certain series of equity, thereby postponing the significant legal costs of issuing stock, etc. and the possible dilution of the founders’ equity and control.

How do you use a convertible note purchase agreement?

If a company has decided that it is going to raise money by issuing convertible debt, it will need at least three main documents: 1) a convertible debt term sheet, 2) a convertible note purchase agreement, and 3) a convertible promissory note. If the debt is to be secured, then a security agreement will also be necessary.

Convertible Debt Term Sheets

As with any term sheet, a convertible debt term sheet (sometimes called a convertible note term sheet) should be prepared first and is used as a negotiating tool to nail down the major terms of the deal before the definitive agreements are drafted. Term sheets are usually non-binding and for discussion purposes only. The convertible debt term sheet should, at minimum, cover the following deal points:

  • The maximum and minimum amounts of money being raised in the proposed financing
  • The maximum and minimum amounts of each convertible promissory note
  • The closing date (or a date range if there may be multiple closings)
  • The maturity date of the convertible promissory notes
  • Whether or not the convertible promissory notes may be prepaid (and if so, pursuant to what terms?)
  • The terms of the conversion (e.g. is the conversion automatic, and if so, what triggers the automatic conversion, what is the conversion price, and what rights will the newly created equity impart?)
  • What happens if the company is liquidated or sold/acquired before the conversion
  • The interest rate
  • What counts as default
  • How the company will use the proceeds
  • How the payments will be applied (e.g. first to interest and then principal)
  • A summary of the representation of warranties to be made by the company and the investors

This list is not exhaustive. The terms that will need to be addressed will depend on the complexity of the deal.

Convertible Note Purchase Agreements

The convertible note purchase agreement will contain all of the terms agreed upon in the convertible debt term sheet and be signed by the company and all of the convertible promissory note purchasers. In addition to the terms listed above that should be included from the convertible debt term sheet, the convertible note purchase agreement should address the following:

  • What is to be delivered at the closing(s)
  • Conditions to closing
  • The entire representations and warranties of the company and the investors
  • Ancillary agreements (that will need to be executed in the event of conversion)
  • All other terms that your attorney deems advisable

This list is not intended to be exhaustive. The scope of the note purchase agreement will vary based on the underlying deal.

Convertible Promissory Notes

The convertible promissory note is the instrument by which the debt is created. Because a convertible promissory note can be converted into equity, it is a security. As such, all applicable federal and state securities laws must be followed. Like any other promissory note, a convertible promissory note can be secured or unsecured.

If it is secured, that means that the debtor has pledged certain collateral to secure the amount owed pursuant to the note. The convertible promissory note will contain all the relevant agreed upon terms that were negotiated in the convertible debt term sheet and other standard promissory note provisions such as:

  • The priority of the note with respect to other indebtedness
  • What happens in the event of default
  • Whether the note is assignable
  • All other terms that your attorney deems advisable

Promissory notes only need to be signed by the debtor. The holder of the note will take physical possession of the note.

Every deal is different and the deal documents will need to be tailored. Please consult with an attorney when considering whether a convertible debt deal is right for you. It is also advisable to consult with a CPA about the tax consequences of this or any type of deal.

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About the author

Lauren Roberts

Lauren Roberts

Lauren Roberts focuses her practice on corporate transactions. She has experience representing a wide variety of clients in complex transactions including multi-million dollar mergers and acquisitions and venture capital financings. In connection with her transactional experience, Ms. Roberts has conducted extensive due diligence reviews. Ms. Roberts also has years of experience with entity formation and general corporate and intellectual property matters such as trademarks and copyrights. She is familiar with Colorado, California, and Delaware corporate law and entity structures.

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