Taking Down the (Corporate) Roof – What Are Convertible Notes?

A convertible note is a short-term debt instrument that later converts into equity. A convertible note is issued when investors make a loan to a company, with the note then ‘converting’ into shares in that company under circumstances known as ‘trigger events’. They provide an alternative to basic debt instruments (e.g., loans) or straight equity (e.g., ordinary shares).

Trigger events may include:

• Companies raising another round of equity investment through issuing shares to investors (i.e., qualifying financing); or
• The company being sold, or offering its shares through an Initial Public Offering (IPO) (i.e., an exit event) or
• The note reaching its maturity date, where the loan amount must be repaid or converted if another trigger event hasn’t occurred (i.e., the end of the loan).

 

Advantages

As opposed to issuing shares, issuing convertible notes doesn’t require a company valuation. This is particularly beneficial for start-up businesses who may not have sufficient data to accurately set a valuation, or during times when a company valuation is uncharacteristically low.

Issuing convertible notes are also often more cost and time-efficient than other alternatives – such as shares – as they require less legal documentation and have comparatively minimal regulatory requirements.

Further, convertible notes can provide flexibility. For example, you can include a right to choose whether to receive shares upon a trigger event, or have the note repaid in cash. You may also request that the note contains an option to convert into shares at any point in time, even if a trigger event hasn’t occurred. Convertible notes can often be negotiated on more favourable terms for earlier investors (e.g., discounted rates, valuation caps, or interest accrual (to be paid upon conversion)) as opposed to those who invest in later rounds.

Given a convertible note is a type of loan, if a company goes into liquidation, it will be required to repay this debt. This is unlike shareholders, who are not entitled to receive the money they paid for shares if a company goes into liquidation. This can reduce the risk associated with investment, with convertible notes expected to increase in popularity during periods of uncertain or unstable equity market conditions.

 

Disadvantages

Convertible notes can, however, also be associated with greater risk exposure. Particularly concerning start-up businesses, if a company goes into liquidation while the note is outstanding, there may be no funds remaining to repay the debt. Further, there are additional risks that a trigger event may not occur, meaning that the loan will not be repaid (if there are no clauses providing otherwise).

While holding a convertible note, you may also not have shareholder rights (e.g., voting power, or a claim to dividends). This means that your influence over the company’s operations will be limited compared to a shareholder or director. Issuers of the convertible note may consider this beneficial, however, as the company can gain funding without providing rights to lenders.

This article was prepared with the assistance of Clea Philips.