If you’ve decided to invest in a start-up company, you may need a lawyer's expertise for a convertible note. This investment is an exciting but somewhat complex process involving a formal agreement between a seed investor and issuing company with several vetting levels and legal forms. One form investors will encounter when investing in a start-up is the convertible note.
A convertible note is a type of short-term debt often used by companies not ready for valuation yet. These notes are then repaid by converting them into equity later, typically when the start-up secures future financing. In this article, we will discuss the role of a lawyer in convertible note investments.
What is a Convertible Note Lawyer?
If a start-up company receives an investment from a venture capitalist but still needs more capital to achieve its goals, it may need to issue additional securities. A convertible note is one of the most common types of such securities. These notes are considered a debt, or loan, to be repaid later.
A lawyer for a convertible note helps the start-up company and the investor to negotiate the terms and conditions of the investment and prepare the convertible note agreement. Typically, this type of investment has terms associated with it, usually outlined in an investor rights agreement, that can be negotiated by both the investor and the start-up company.
Senior Convertible Notes, a Simple Agreement for Future Equity (SAFE), a Keep It Simple Security (KISS), and a Simple Agreement for Future Tokens (SAFT) are other forms of convertible notes.
A convertible note, also referred to as convertible debt, typically has three parts:
- A description of the investment being made
- The amount being invested and when it will be paid back to the start-up company
- The conversion price or discount at which the investor can force conversion into equity in future rounds
The document also provides for certain events that would allow both parties to terminate the agreement with minimal penalties (e.g., bankruptcy).
A convertible note lawyer may also help negotiate the terms of converting the investment into equity. Converting a convertible note into equity requires two steps:
- Step One: There must be another round of financing where equity can be sold at a higher valuation than in previous rounds
- Step Two: If necessary, an amendment must be made to increase the number of shares available for issuance as well as their face value
Some convertible notes have provisions that allow them to convert automatically if certain conditions are met without requiring any action by either party; this provision is increasingly common in more sophisticated transactions.
Here is an article where you can read more about convertible notes.
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What Do Convertible Notes Do?
Convertible notes are a financing mechanism that allows an issuing company to convert its debt into equity. They are generally issued in series and have an expiration date on which the full amount of the note must be repaid.
The borrower is then given a predetermined period of time to raise an equity round (or “follow-on”) so that they can pay back the entire loan, as opposed to just the remaining principal.
The benefits of convertible notes to seed investors include:
- Discounts on future rounds. Because this financing reduces risk, an issuing company may offer smaller discounts on future rounds.
- Better valuation control. Since issuing companies don't have to negotiate with existing shareholders for discount terms, they can have more bargaining power.
- Faster time-to-exit. In case things go wrong, issuing companies can get out quickly without waiting for exit events like IPOs or acquisitions.
How Much Does a Lawyer for a Convertible Note Cost?
A lawyer for a convertible note will cost between $250-$1,000 per hour. Their total fee typically includes an hourly fee and any applicable retainer fee. The hourly fee is typically 1/3 to 1/2 of the total fees that you pay your lawyer.
The retainer fee is charged upfront and covers the costs involved with drafting and negotiating your convertible note agreement. It also determines how much your lawyer can spend working on your documents.
These are the usual fees associated with hiring a lawyer, however, it is common for convertible note lawyers to work on a contingency basis. This means that they only get paid when the start-up company raises money.
Here is an article that covers more examples of convertible notes and explains how they work.
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Key Terms in a Convertible Note
Convertible notes are a popular funding round for start-ups. If you're raising money with a convertible note, here are terms to consider adding before you sign:
- Notice of Conversions. A notice of conversion is a formal document that an investor submits to the company when they want to convert their investment into equity.
- Conversion Price. The conversion price is the price per share the investor will receive when they convert their investment into equity.
- Conversion Discount. The conversion discount is the percentage discount the investor will receive on the equity price when they convert their investment. For example, if the conversion price is $0.50 per share and the equity price is $1.00 per share, the seed investor will receive a 50% discount on the equity price.
- Cap. The cap is the maximum price per share the investor will pay when converting their investment into equity. For example, if the cap is $1.00 per share and the equity price is $2.00 per share, the seed investor will only pay $1.00 per share when they convert their investment.
- Interest Rate. The interest rate is the percentage of the principal investment that the investor will accrue as interest.
- Maturity Date. The maturity date is the date on which the investment will mature, and the investor will be able to convert their investment.
- Warrants. A warrant is a type of security that gives the holder the right to purchase shares of the company's stock at a set price. Warrants are often included in convertible notes to sweeten the deal for the seed investor.
Here is an article about the terms in convertible notes.
Do I Need a Lawyer for a Convertible Note?
The short answer is most likely. Convertible notes are a popular financing mechanism that allows start-ups to raise capital without giving up an equity stake. However, while a convertible note can be a great investment option for many issuing companies, conversion can be tricky, and several factors determine the outcome.
This is because many potential pitfalls associated with convertible notes can be detrimental to the investor. Some of the potential risks include the following:
- The convertible note may be structured in a way that could be more favorable to the investor.
- The start-up may need help to raise additional funding, meaning that the investor may be stuck with a debt that cannot be converted into equity.
- The terms of the convertible note may be changed at the discretion of the start-up, which can be detrimental to the investor.
Overall, convertible notes can be a great investment for many start-ups, but it is important to know the potential risks before becoming a seed investor. Again, an experienced lawyer can help you navigate the complex legal landscape and protect your interests.
Here is an article about different forms of convertible debts.
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