Convertible notes offer an alternative when assessing business financing options.
As a business attorney, I am often asked by our clients, “how should I fund my business.” My first response is always “with money.” I say that tongue and cheek, knowing what my client is really asking is, “where do I find money to grow my company and what do I have to give up to get it.” And to that question, there are many answers, but one solution that has been growing in popularity for a few years now is “with convertible debt.”
First, let’s exhaust a few potential funding sources before we unpack the nuances of the convertible note, which, by the way, is popular year-round and in any climate. The easiest way to fund a start-up or pre-revenue venture is with your own money. The next best way is to convince your rich relative that they should give you some of their money simply because they love you and in which case it becomes your money, with some potential negative tax consequences. Next option I always suggest —your bank. SBA, LoC, HELOC, etc.
I speak to students of all ages at UMKC, the Kauffman Center, and the KU School of Business about entrepreneurship and the law. There is a common misperception amongst these students that all you need is a good idea to take to some rich investors somewhere and they will write you a check for millions of dollars. OK, maybe I’m exaggerating, and perhaps I’m a little jaded when it comes to any scenario close to that, but that sequence of events couldn’t be further from reality.
What is a realistic approach, after exhausting the options above is offering a potential investor the best of both worlds—debt or equity? That’s what a convertible note does. It gives the investor the ability to lend you money, with security and payment terms, while giving them upside. That upside is the mechanism to trade in the debt they have provided you for direct ownership in your company. They can do it under the terms of the note when they see that they chose to take a chance on a winner—a company that utilized the money they borrowed to become profitable. What’s better than that? Name a better way to fund your pre-revenue unicorn; I’ll wait… Inside the Framework
Convertible notes give investors the ability to lend money, with security and payment terms, while giving them a chance to share in the company’s ownership.
OK. Let’s drill down on the framework of a convertible note. A convertible note is a security under federal and state securities laws. Therefore, in order to take advantage of Rule 506(d) of the Securities Act of 1933, the company should make sure their investors our accredited investors and that anyone the company is paying to help raise capital is a registered broker dealer. As a security, a convertible note is first and foremost a loan. A loan, which traditionally has principal, interest, a term, repayments and amortization. However, a convertible note is primarily short-term debt (usually a year or 2) in which the investor receives an option to convert this debt into ownership in the borrower entity. The conversion can work both ways. This means that the investor usually has the option to convert it prior to the maturity and forgo the repayment of the debt or it automatically converts to equity if the debt has not been paid by the maturity date.
One important aspect here is that the company and the investor can determine the valuation of the company at a later date when the company goes out to raise additional funding. However, investors must be careful not to allow the repayment terms or the conversion at maturity to get pushed out too far. This can allow the company to increase the valuation in an effort to diminish the value of the equity being converted. This can feel like the future equity is being diluted, because in theory, it is. Conversely, this may push an investor to convert the debt to equity sooner if the company shows profitability at an early stage. Finally, convertible noteholders generally enjoy a discount rate on future raises for taking a risk at such an early stage.
Convertible debt continues to gain popularity and that means that it continues to evolve. There are many nuances to making a convertible note do what it needs to do in order to satisfy both the investor and the early-stage company. At the end of the day, it is a great option to fund your company and often an even better option to invest in one.