What is Convertible Note Drafting?
A convertible note is a short-term loan commonly used by startups to raise capital they need to get off the ground. At a later stage, it gets converted into equity instead of being paid out in cash.
There are important terms to include in convertible note agreement to ensure clarity and legal validity.
Read the rest of this article to learn more about how convertible notes are drafted and how a lawyer can help you with them.
What’s Included in a Convertible Note Agreement?
Some common key terms are usually included in a convertible note agreement, such as the following:
- Principal amount. The total loan amount that the investor invests.
- Interest rate. The interest that builds up over time and gets added to the principal.
- Maturity date. The date by when the company has to transform it into equity.
- Conversion discount. The percentage discount that’s applied to the share price of the next funding round.
- Triggering events. Conditions or events that start the process of transforming debt into equity.
- Valuation cap. The maximum valuation at which the note can convert. It serves to protect early investors from dilution in later rounds.
- Exit event. This occurs when the business is sold and can include scenarios such as an asset sale or initial public offering (IPO).
How Does a Convertible Note Work?
The process of using convertible notes usually follows these steps:
- The investor invests a specific amount of capital into the company, in the form of a loan which bears interest.
- The company commits to repaying the loan by a specified time.
- The investor can transform the loan into shares upon a triggering event. If not, the company repays the loan, but this option depends on what is included in the convertible note agreement.
What are Tips for Drafting a Convertible Note Agreement?
There is no such thing as a standard convertible note, meaning that the note agreement will have to be customized to suit the specific situation and transaction. However, when drafting a convertible note agreement, there are some important things to consider.
Consider Investor Rights
For clarity, the convertible note should include noteholder rights, such as that they can’t vote at shareholder meetings if they don’t own shares. There should also be provisions made to protect investors, such as by giving them the right to access the company’s financial records, which can include reviewing budgets and financial statements.
Include Confidentiality Terms
The involved parties should know that they can’t share convertible note arrangements with others. This protects the company against unauthorized disclosure of sensitive information that could harm their reputation or competitive position.
Make it Clear
The entire agreement must be drafted in a specific, transparent way that’s easy for all parties to understand. It should avoid any vague or ambiguous terms that can create issues or disputes. For increased clarity, consider adding a definitions section.
Customize the Agreement
Consider the parties’ goals, risks, and any industry-specific issues when drafting the agreement so that it’s tailored to your specific transaction.
Specify the Conversion Details
A common mistake when defining convertible notes is not specifying what happens when notes convert into equity, which can result in dilution (and other) uncertainty.
Avoid Unrealistic Valuation Caps
Getting the valuation right is important. If the valuation is too high, it can result in high equity. By comparison, if it’s too low it can make it too challenging to meet in the next round of financing.
Keep it Concise
Although a convertible note should be transparent and include key terms, it shouldn’t be too complex or lengthy as this can be a deterrent for future investors.
How Can a Lawyer Help You With Convertible Note Drafting?
Since convertible notes can be challenging and complex, they require a professional lawyer to draft them. Here are some ways in which they can help you navigate the process.
A lawyer will:
- Structure the convertible note so it meets the company’s funding goals.
- Ensure all investor interests are outlined and protected in the agreement.
- Check that the convertible note is aligned with all securities and other laws and regulations.
- Draft clear agreement terms, such as regarding valuation caps, to prevent ambiguity that can result in disputes.
- Spot any hidden risks you might have missed, such as regarding dilution or conflicting investor rights.
- Negotiate with the other party for more favorable terms.
- Customize the convertible note so that it isn’t generic but instead addresses all commercial realities and real-world situations.
- Check that the agreement is aligned with other company important documents, such as shareholder agreements.
- Prevent errors that can make the clauses lack legal validity.
- Give you the confidence to start an efficient fundraising process without any uncertainty.
Where to Find a Lawyer for a Convertible Note Drafting
If you need to hire a lawyer for help with a convertible note drafting, you don’t have to find the process challenging or time-consuming. Online legal networks make the process much easier. On ContractsCounsel, one of the largest online legal networks that connects clients with vetted lawyers, you can find an experienced lawyer to help you draft a convertible note.
Here’s how to request a convertible note drafting in five easy steps:
1. Go to the ContractsCounsel marketplace, where you can post your project or request for free.
2. Specify some details of what you require so lawyers know how to help you.
3. Wait for lawyer bids. You’ll receive multiple bids from lawyers directly on the platform.
4. After receiving lawyer bids, you should review the lawyers' profiles. The platform provides a range of lawyer information, such as regarding their location, client ratings, years of experience, and field of expertise.
5. Connect with a lawyer you think is best suited to your requirements and hire them to draft your convertible note.
