Convertible Promissory Notes - What They Are and How They Work

By Lawrence Tepper

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:

1. 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.

2. 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.

Convertible notes are hybrids securities that offer some protections due bondholders-- shelter from liability and senior status if insolvency occurs, with a predictable income--and the potential for upside gain if the equity does well.
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
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Where to Invest Money When the Sky Is Falling

By James Leitz

Most of us know where to invest money in good times, but when it looks like the sky might be falling, knowing where to invest money and how to invest it becomes a puzzle. In 2014 and 2015 good investments might be hard to find, especially if yesterday's good investments like stocks and bonds tank. This is not a prediction, but rather a "heads up." You can't prepare if you're not aware, so let's take a closer look at the sky.
We all know that safe choices like money market funds and bank savings accounts don't look like good investments for 2014 because they pay peanuts. But what if the sky starts falling: either interest rates ignite and/or the stock market tanks? Either way or both... where to invest money is the question of the day. Safe choices will look like good investments for parking money that must be safe.
Wall Street's traditional answer to where to invest money: put about 60% into stocks with about 40% in bonds holding a cash reserve on the sidelines. Problem: in 2014 and 2015 losses in stocks may not be offset by gains in bonds... as was the case for the last 30 years or so. If interest rates soar from today's record-low levels, neither stocks nor bonds look like good investments.
For over 30 years interest rates were falling and bonds were generally good investments. With today's ridiculously low rates (created by our government to stimulate the economy) a rebound in interest rates is in the cards (as the government unwinds its stimulus). When that happens, bonds will no longer be where to invest money for higher interest income with relative safety. Bonds are NOT good investments when rates go up; they lose money. That's the way it works. How to invest in bonds in 2014 and 2015 if rates take off: lighten up and opt for safety.
Stocks had been very good investments five years running as the year 2014 began. This was at least in part due to government stimulus and cheap money. In a sense, stocks were where to invest money because nothing looked cheap except for money (short term interest rates were set at about one-tenth of one percent). With a gain of over 150% in five years, the downside risk in the stock market is mounting. This begs the question of how to invest money in stocks if the sky starts to look ominous.
Remember that the stock market is actually a market of stocks, which means that the vast majority of stocks get hit when the market crumbles - but at least a few will be good investments. And the best way to find good investments in a bad market is to watch the price action. For example, as the market climbed 30% in 2013, some gold stocks were down about 50% by early 2014. If you don't know how to invest in or how to pick a specific gold stock... you might want to know where to invest money to get a piece of this action. The answer is to invest money in gold funds and let them pick the gold stocks for you.
The bottom line is that in 2014 and 2015 investors face an uphill battle, because both stocks and bonds look pricey. That presents a new challenge to today's investor in search of where to invest money. We are facing uncharted waters in this modern electronic world, where no one really knows how to invest or where to find good investments for the future. This includes the big investors like life insurance companies and pension funds.
My suggestion is to take some profits in your stocks and bonds, because the tide will turn eventually if not in 2014 or 2015. Then you'll have a cash reserve, so you can take advantage of the situation as the skies darkens. Smart investors are always in search of where to invest money next, especially when a change of trend is in the cards. At such times, yesterday's underperforming sectors or industries often become today's good investments.

A retired financial planner, author James Leitz has an MBA (finance) and over 40 years of investing experience. His complete investor guide for beginners, Invest Informed, teaches everything you need to know to put your money to work. Review his book, INVEST INFORMED at http://www.Amazon.com.

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