Convertible Promissory Notes - What They Are and How They Work
What is a convertible promissory note?
A convertible note is a debt instrument, similar to a bond that may be convertible into equity (common stock) at a future date. The conversion may happen upon the occurrence of certain events or at the choice of the investor. The conversion feature is the mechanism by which the debt (the note) will convert to equity (new shares for the investor) upon a future event.
Most convertible notes are issued by smaller, less established or speculative corporations to raise money for investment and business operations.
What are the common elements of a convertible note?
There are two primary elements:
Why are convertible notes issued?
New business ventures and small operating businesses often have difficulty obtaining capital (whether for starting up, or for expanding operations). During economic downturns this is especially true because loan underwriting standards are tightened. But, at the same time, a number of investors often seek non-traditional investment opportunities to enhance their portfolios. A convertible promissory note provides an opportunity to serve the needs of both the business needing capital and the investor seeking an opportunity.
Another benefit to the issuing companies, which may be smaller and less established companies, is they would have to pay a prohibitive interest rate to issue a conventional bond. Issuing debt as a convertible allows them to pay lower interest rates to borrow money than they otherwise would.
Why invest in a convertible Note?
The investor interested in a convertible note is not primarily interested in a simple interest yield. The convertible note investor seeks eventual ownership (common stock equity) in the business. The investor is classified as an "early stage investor" who is taking a tremendous risk in funding a start-up business or a small business needing additional capital. By becoming equity investor he may participates in the upside of the company, if it succeeds.
What is the conversion discount and how does it work?
As a sweetener or added benefit, the convertible promissory note investor has a "conversion discount" feature"; this feature allows the convertible note holder to exchange the note for newly issued securities at a price per share equal to 80% (this amount can very per deal) of the price per share paid by the buyers of the newly issued securities.
Example: Here's the basic outline of how convertible debt works:
(1) Joe Angel invests $100,000 in Startup Company Inc.
(2) Startup issues Joe Angel a convertible note for $100,000. The convertible note has a conversion feature at $1,000,000 (the newly issued stock) with a conversion discount equal to 20%.
(3) Startup closes $1,000,000 Series A Preferred Stock round (the newly issued stock) at a price of $1.00 per share.
(4) Joe Angel now has the option to convert the note into Series A shares at a per share price of $0.80.
(5) The Startup issues Joe Angel 125,000 shares ($100,000/$0.80 per share) of its Series A Preferred Stock. The convertible note is cancelled.
Securities Law Warning
Convertible notes will almost always be considered a security under federal and state securities laws and regulations. It will be necessary for a business contemplating utilizing convertible notes to raise capital to consult with an attorney who specializes in securities law.
Conclusions
Issuing convertible promissory notes can be an effective means for start-up companies to raise capital. However, before raising capital through issuing promissory notes, investors and companies need to carefully evaluate the risks associated with issuing promissory notes in comparison to other financing alternatives.
A convertible note is a debt instrument, similar to a bond that may be convertible into equity (common stock) at a future date. The conversion may happen upon the occurrence of certain events or at the choice of the investor. The conversion feature is the mechanism by which the debt (the note) will convert to equity (new shares for the investor) upon a future event.
Most convertible notes are issued by smaller, less established or speculative corporations to raise money for investment and business operations.
What are the common elements of a convertible note?
There are two primary elements:
- The note. A typical note will state the principal, interest rate, maturity date, whether the note will be secured by assets, default provisions, and the related remedies.
- The equity conversion rights. The equity conversion aspect will state a definition of the event that triggers the right to conversion, the formula used in converting the debt to equity, the type of equity to which the debt will be converted (common stock versus preferred stock), and any additional equity rights attached to the shares converted from the debt, such as voting rights and dividend rights.
Why are convertible notes issued?
New business ventures and small operating businesses often have difficulty obtaining capital (whether for starting up, or for expanding operations). During economic downturns this is especially true because loan underwriting standards are tightened. But, at the same time, a number of investors often seek non-traditional investment opportunities to enhance their portfolios. A convertible promissory note provides an opportunity to serve the needs of both the business needing capital and the investor seeking an opportunity.
Another benefit to the issuing companies, which may be smaller and less established companies, is they would have to pay a prohibitive interest rate to issue a conventional bond. Issuing debt as a convertible allows them to pay lower interest rates to borrow money than they otherwise would.
Why invest in a convertible Note?
The investor interested in a convertible note is not primarily interested in a simple interest yield. The convertible note investor seeks eventual ownership (common stock equity) in the business. The investor is classified as an "early stage investor" who is taking a tremendous risk in funding a start-up business or a small business needing additional capital. By becoming equity investor he may participates in the upside of the company, if it succeeds.
What is the conversion discount and how does it work?
As a sweetener or added benefit, the convertible promissory note investor has a "conversion discount" feature"; this feature allows the convertible note holder to exchange the note for newly issued securities at a price per share equal to 80% (this amount can very per deal) of the price per share paid by the buyers of the newly issued securities.
Example: Here's the basic outline of how convertible debt works:
(1) Joe Angel invests $100,000 in Startup Company Inc.
(2) Startup issues Joe Angel a convertible note for $100,000. The convertible note has a conversion feature at $1,000,000 (the newly issued stock) with a conversion discount equal to 20%.
(3) Startup closes $1,000,000 Series A Preferred Stock round (the newly issued stock) at a price of $1.00 per share.
(4) Joe Angel now has the option to convert the note into Series A shares at a per share price of $0.80.
(5) The Startup issues Joe Angel 125,000 shares ($100,000/$0.80 per share) of its Series A Preferred Stock. The convertible note is cancelled.
Securities Law Warning
Convertible notes will almost always be considered a security under federal and state securities laws and regulations. It will be necessary for a business contemplating utilizing convertible notes to raise capital to consult with an attorney who specializes in securities law.
Conclusions
Issuing convertible promissory notes can be an effective means for start-up companies to raise capital. However, before raising capital through issuing promissory notes, investors and companies need to carefully evaluate the risks associated with issuing promissory notes in comparison to other financing alternatives.
Lawrence (Larry) Tepper specializes in the valuation and
appraisal of promissory notes, mortgage notes, and debt cash-flow
instruments nationally. Nation-wide services for banks, trust companies,
self-directed IRA accounts, estates, attorneys, CPAs, and individual
investors.
Consulting Services-Free Appraisal Price Quotes
EDUCATION AND TRAINING
Law Degree /Accounting Minor University of Denver
Managing Colorado Real Estate Broker-- Promissory Notes Specialization
Certified Commercial Investment Member from the National Assoc. Realtors (CCIM)
PRACTICAL EXPERIENCE
35 + years of national promissory note and mortgage note appraisal and valuation for Banks, Trust Companies, Attorneys, CPA's, Estates, Trusts, Executors, Administrators, and Financial Advisors.
"No charge" review and discussion of your file and documents--Fee appraisal quotes-- Call or email.
Lawrence (Larry) Tepper
303-779-6996
Lawrence.Tepper@comcast.net
http://www.PromissoryNoteAppraisers.com
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Consulting Services-Free Appraisal Price Quotes
EDUCATION AND TRAINING
Law Degree /Accounting Minor University of Denver
Managing Colorado Real Estate Broker-- Promissory Notes Specialization
Certified Commercial Investment Member from the National Assoc. Realtors (CCIM)
PRACTICAL EXPERIENCE
35 + years of national promissory note and mortgage note appraisal and valuation for Banks, Trust Companies, Attorneys, CPA's, Estates, Trusts, Executors, Administrators, and Financial Advisors.
"No charge" review and discussion of your file and documents--Fee appraisal quotes-- Call or email.
Lawrence (Larry) Tepper
303-779-6996
Lawrence.Tepper@comcast.net
http://www.PromissoryNoteAppraisers.com
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