Convertible Promissory Note: What is it?

A convertible promissory note is a form of debt that converts to equity when either a certain event has occurred or a certain date has passed. The conversion from debt to equity will depend on the agreement between the person or company that has issued the note and the investor.

The two parts of a convertible promissory note are the promissory note and the equity conversion rights. 

A typical promissory note will have the principal, the interest rate, the maturity date, how the note will be secured (usually by assets of the company), and details of what will happen if there is a default.

The equity conversion will include an explanation of the event that will trigger the conversion. It should also include the formula used in converting the debt to equity, the type of equity the debt will be converted into (common stock or preferred stock), and any additional equity rights that the investor will gain from converting the debt, such as voting rights or dividends. 

For example: BB Financing is a financial services company that requires $250,000 in funding to achieve its one-year goals. BB Financing attracts two investors, John and Barry, by offering them convertible promissory notes of $125,000 each. John and Barry's notes will automatically convert once BB Financing raises $1.5 million in equity. Seven months later, BB Financing receives $1.5 million in financing. The two convertible promissory notes are then converted into equity, effectively canceling the notes.

Why Use a Convertible Promissory Note?

There are a few reasons to use convertible promissory notes when trying to raise capital for your business. 

  • They are the easiest and quickest way to work with investors. There is very little legal work to be done when using a convertible promissory note. Many experienced investors don't want to involve expensive legal counsel in most convertible debt investments. A term sheet for a convertible promissory note deal might be two or three pages, while a Series A preferred stock financing deal could be between eight and 10 pages.
  • It allows companies to raise capital without having to put a valuation on their business right away. Often, if a company has just started or has not even launched yet, valuing the business is nearly impossible. In convertible debt financing, the investment is made without placing an explicit valuation on the startup.

Risks of Convertible Promissory Notes for Investors

Investors are often taking a very large risk by financing a company that is just starting up. Later investors usually have better bargaining power, especially if the company really needs financing. This means that initial investors usually don't get as good a deal and are unable to renegotiate the terms of the note.

Usually, initial investors aren't well-compensated for all of the investments that they put into the early stages of the company. Besides the monetary investment, they are giving client contact details, making introductions with suppliers, and adding credibility to the company with their name.

If the value of the company grows because of the investor's efforts, the investor is actually increasing the price they will pay for their own equity in the company. 

Investors in convertible promissory notes are creditors to the company until the notes convert to shares. This means that if the company goes bankrupt, they may lose their investment entirely. If the company is sold before the note converts, then the investor is only entitled to their principal and interest.

Risks of Convertible Promissory Notes for Companies

Convertible notes are great for a company if its value increases from the time of the initial financing to the time they issue their first preferred stock. If this doesn't happen or the company actually decreases in value, the initial investors who bought convertible promissory notes could end up owning more equity in the company than the company anticipated.

The equity purchased by the investor usually has a liquidation preference, so in addition to getting greater equity in the company at the expense of the business owner, investors probably also get preference over the owners to the cash of the company in the case of a sale, dissolution, or closing up of the company. 

Another risk of convertible promissory notes to a company is if a convertible note is not converted into equity before maturity, investors could demand that the note is repaid with principal and interest. This could potentially put the company into bankruptcy. 

What Is Included in a Convertible Promissory Note Contract?

  • Principal and Interest — How much will be given to the company and what will their interest rate be?
  • Maturity — This outlines exactly when the company will repay the principal and interest if it has not been converted into equity.
  • Conversion — This should outline exactly what will occur in order for the note to be converted into equity. This can be if the company raises a certain amount of financing or can be set to convert at the investors' discretion. It can also be decided that the note will convert at the time of maturity.
  • Mechanics of Conversion — This section outlines how the investor will convert the note into equity. It usually requires the investor to hand over the note in order to receive company shares.
  • Payment — This outlines how the repayment will work. It is not in the interest of the investor to have the company pay the money back quickly and without much interest accrued, so that is usually mentioned in this part of the note.
  • Representations and Warranties of Lender — This section is required by securities laws and explains exactly what the investor is allowed to do with their equity as well as with the note before it converts to equity.
  • General Provisions — This final section is where any other issues that either party wants to address should be placed. This includes the jurisdiction of any disputes that may arise and explanations about how to make amendments to the agreement.

Frequently Asked Questions

  • What is preferred stock?

Preferred stock is a type of equity ownership in a company that includes certain perks. Investors who hold preferred stock usually receive cash distributions before investors of common stock. They also have certain rights over the running of the company, such as the ability to veto certain activities.

  • What happens if the maturity date is reached and there hasn't been any additional financing?

If your convertible promissory note was based on the fact that the note would be converted when additional financing was raised, then a company usually has four options. They can pay back the investor in full with the interest that was agreed upon, they can ask the investors for an extension on the maturity date, they can convert the note into preferred stock, or they can convert the note into common stock.

  • What is convertible debenture?

While a convertible promissory note is usually unsecured, meaning you don't need to put up collateral against it, a convertible debenture requires the company seeking financing to put up some collateral in case they are unable to pay back the principal and interest. It usually includes other protective provisions that benefit the investor.

  • What is SAFE?

SAFE stands for Simple Agreement for Future Equity. SAFE is like a warrant that entitles investors to shares in the company, usually preferred stock, if and when there is a future valuation event. These documents are usually longer than convertible promissory notes, there is a loophole that allows dividends to be paid to common holders and not SAFE holders, there is no interest accrued as with a promissory note, and there is no minimum fundraising amount for the next equity round that would trigger the conversion.

  • Is a convertible promissory note always classed as a security?

No, it is not always considered a security. Many securities lawyers believe that a convertible promissory note is always a security because a convertible note is an investment of money in a company with profits that will come solely from the efforts of others. This is how the law defines something as a security. Yet, a convertible promissory note is not always changed into stocks, in which case it is actually a loan, not an investment.

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