What is a Convertible Note Offering?
A convertible note offering is a type of financing in which investors lend money to a startup company to help them with funding. Instead of receiving money for it, the loan gets converted into ownership shares later.
It’s common for convertible notes to be used by companies during early investment rounds, but they can also be used as bridge loans to fill a gap during extra funding rounds.
Read the rest of this article to explore how convertible notes work, their key aspects, and how a lawyer can help you with them.
What are Key Aspects of a Convertible Note Offering?
There are some main aspects of a convertible note offering. These include the following:
- Principal. This is the amount of money an investor loans to the company.
- Maturity Date. It’s common for convertible notes to last for 18 to 24 months. The note will convert from a loan to equity ownership by the maturity date. Investors can request repayment when the convertible note matures, but the company can extend the maturity date if they haven’t got enough equity financing by then.
- Conversion Milestone. This term refers to when the note is converted into equity. It’s common for a convertible note to convert at the company’s next financing round.
- Conversion Pricing. This determines the number of shares that the investor will get when the note is converted. Pricing is commonly based on the next financing round’s valuation. A discount can be applied to motivate the investor.
- Cap. This is a valuation on a company in which the investor converts their shares. It can protect early investors so that the company can’t increase their valuation too much in next financing rounds.
- Interest Rate. Interest will accumulate on the loan and be paid out at maturity. So, when the convertible note becomes equity, the loan amount and built-up interest will both be converted with the loan.
What Documents Are Required for Convertible Note Offerings?
One of the benefits of using convertible note offerings is that they are cost-effective, not requiring many documents. The most essential paperwork includes:
- Term sheet. This document provides information about the investment, such as the main amount, interest rate, valuation cap, and investor rights.
- Convertible promissory note. This states the company’s promise to repay the investor’s money, such as by converting it into equity. It should specify details about various aspects of the conversion, such as conversion triggers and defaults.
- Subscription purchase agreement. This document can be seen as a way for the investor to formalize their commitment to buy the convertible note. Closing conditions will be included, as well as representations from the investor and company.
- Private placement memorandum (PPM). This discloses the offering by providing company and offering details for investors.
What are Pros and Cons of Convertible Note Offerings?
Convertible note offerings have advantages and disadvantages for both companies and investors. These include the following.
Pros
- Investors can reduce their risks. Holding the debt and converting their money to equity when the company has built their capital means investors don’t get exposed to early-stage uncertainty.
- Convertible notes can be simpler than other offerings. The company doesn’t have to be an LLC or C-corp to issue convertible note offerings to build their capital. This also means less paperwork.
- Investors get discounts. These are like rewards for them taking an early investment risk.
- Companies have greater flexibility. Companies have the chance to raise capital from multiple investors.
Cons
- The company might not raise enough equity financing. Some convertible notes don’t have provisions for automatic conversion, which can result in disputes with investors.
- There’s a risk of dilution. Founders and early team members risk ownership dilution if the caps and discounts are set too high.
- Investor rights are limited. Investors who own convertible notes usually have limited voting rights in the company.
What is the Convertible Note Offering Process?
The process of issuing convertible notes usually contains the following steps:
- Making an investment. The investor invests an amount of money.
- Accrual. The convertible note builds interest at the agreed-on rate until a trigger event occurs.
- Trigger event. This is basically a milestone that starts the conversion, such as a financing round or a maturity date.
- Conversion. The note gets converted into shares.
- Exit. Investors have the opportunity to sell their shares, such as during an acquisition.
How Can a Lawyer Help You with a Convertible Note Offering?
While you might not think of hiring a lawyer for convertible note offerings, this is advisable. They will help you to structure and execute the offering correctly so you don’t have to worry about making any mistakes that could be costly or affect future funding rounds.
Although you might assume that convertible note offerings are simple and straightforward, they can involve complex financial terms and securities laws you don’t want to get wrong.
A lawyer will:
- Align the offering with all securities regulations to avoid penalties or disputes with investors.
- Draft and review essential offering documents so all terms are enforceable and transparent.
- Negotiate terms in the offering, such as caps and interest rates.
- Identify risks that you might not realize, such as vague language in documents that reduces your flexibility in future rounds of funding.
Where to Find a Lawyer for a Convertible Note Offering
If you’re looking for a qualified lawyer to help you with a convertible note offering, this doesn’t have to be a time-consuming process. On online legal platforms like ContractsCounsel, this process is easy.
ContractsCounsel is one of the largest online legal marketplaces with more than 1,000 lawyers on its platform. It provides access to qualified lawyers with years of experience in helping clients with convertible note (and other) offerings. All lawyers have been vetted on the platform and will guide you through every step of the process, whether you’re a company or investor.
