Convertible Preferred Note: Everything You Need to Know
A convertible preferred note is a type of short-term debt that is typically loaned by investors of start-up businesses.3 min read
A convertible preferred note is a type of short-term debt that is typically loaned by investors of start-up businesses. Upon later valuation and funding, the note can be converted into equity.
Defining a Convertible Note
As a form of short-term debt that can convert into equity, a convertible note can also include protection from contingencies such as:
- Failure to meet the investment by the loan's maturity date
- Selling of the business before conversion
Convertible notes and SAFE are both tools that are often used for early investments of new companies with strong potential.
LLCs and Convertible Notes
Although LLCs can use convertible notes, it is not common practice because most venture capitalists prefer to invest in a corporation. This preference is due to the following:
- Corporations provide equity through their shares while LLCs offer ownership interests.
- Corporations have a more extensive case law history concerning legal matters.
- LLCs are subject to pass-through taxes so their funding could affect the investors' firms.
There are two circumstances that can prompt a note conversion:
- A funding round
- An acquisition
For an LLC to prompt a funding round, it will likely need to terminate its LLC status and begin a C corporation. Furthermore, the operating agreement of the LLC must discuss the transfer of the title from investors to owners.
The Difference Between Convertible Notes and Preferred Stock
The two most common types of investment vehicles used during the start of a business are convertible debt and preferred stock.
Preferred stock is a type of stock that is sold to venture capitalists. Typically, preferred stock offers the following benefits to its holders:
- A seat above common shareholders in the event of liquidation
- Protection from anti-dilution
- Priority in the order dividends are distributed
- Board assignment
- Application of certain contractual benefits
Convertible notes are a successful form of debt for companies when they meet the following standards:
- The company has a sizable valuation at the time of the conversion trigger.
- The valuation can be achieved quickly so as to be complete before the maturity date.
- The company can deliver either no price cap or a steep price cap.
Preferred stock is successful for companies that can establish a decent valuation upon triggering and accept additional legal costs.
Advantages and Disadvantages of a Convertible Note
There are many advantages and disadvantages of convertible notes. Some advantages include:
- They have a simplistic arrangement with less complications.
- They offer pre-valuation investment.
The main advantage that convertible notes hold is their simple form. Oftentimes, beginning financial rounds can become difficult, time consuming, and expensive. Convertible notes offer a fast, easy, and inexpensive form of financing.
Equity-based investments actually sell shares of the company while convertible notes are a type of debt. This means that the company does not need to issue more stock or establish a new form of shares. Furthermore, it avoids problems caused by following scenarios:
- Company valuations
- Stock option grants
- Tax involvement
The valuation of a company prior to investment is considered the most important and frustrating aspect of an equity-based investment. It is important because it is used to determine the value of the company that will be offered. However, this value is not easy to come by, making it a frustrating process.
Convertible notes provide investors with the ability to hold off on valuing the company until a later financing round. This gives the companies time to establish measurements that can be used to calculate a valuation.
Some additional advantages that convertible notes offer to investors include:
- Protection from dilution
- The conversion of a note into equity at a discount rate
- A more favorable price share based on the maximum valuation cap
Some disadvantages of convertible notes include:
- Certain investors are opposed to convertible notes.
- They lack control.
While it can be considered an advantage that convertible notes do not require an immediate valuation, this lack of valuation can make it challenging for investors to determine if the offer of the note is trustworthy. Because of this, some investors, knowing their increased cost, still prefer equity-based investments.
Furthermore, investors using convertible notes do not have the ability to influence the result of their investment the way they would using an equity-based investment.
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