MSN Law Office

Convertible Notes
Columbus, Ohio

Convertible Notes
Simple Agreements for Future Equity
Equity Seed Investments
Private Placements
State Blue Sky Laws

Raising Money From Investors

PRACTICE AREAS

Convertible Notes

There are many different ways for a startup or small business to raise money from investors. Even if you are dreaming about one day raising venture capital, your startup will likely go through one or more rounds of funding from seed investors. In other words, you will probably have to raise money from friends and family and angel investors first. 

One common option offered to seed investors is a form of debt financing known as the convertible note. Like any promissory note, a convertible note will specify the note’s principal balance, a fixed interest rate (which often accrues and is added to principal rather than actually being paid each month), and a maturity (or repayment) date. While these notes are usually short term (i.e., 1-2 years until the maturity date), they can also be structured in such a way that the notes are left outstanding even after the maturity date because the note holders are really waiting for the opportunity to convert the note to equity. A convertible note will usually also give the note holders “priority” for repayment ahead of the company’s members or shareholders should the business be liquidated. 

Early seed investors like convertible notes because, as the name implies, they can be converted into equity in the company if the startup grows more successful. In other words, if a potential investor is interested in a convertible note in your early stage startup or small business, their goal isn’t really to get repaid for their loan. Their goal is to see you grow the business to either attract larger investors or a larger purchaser who will buy your company. 

The notes will usually convert upon the occurrence of certain events:

  • Next Equity Financing: If and when your company issues a certain amount of equity to future (usually larger, possibly even venture capital) investors, the seed investors will convert their principal and interest into equity for less than the price being paid by the later investors. 
  • Transaction Conversions: If the company is sold (or substantially all of the assets are sold), seed investors can elect to either be paid the outstanding principal and interest or (more likely) convert their notes into equity (again, at a discount) and be paid a share of the purchase price.  
  • Maturity: If all else fails and the maturity date passes before another type of conversion event is triggered, the investors can exercise a couple of different options:
    • convert the note to equity based on a predetermined value; 
    • demand repayment (though companies in this position rarely actually have the cash or assets to repay seed investors); or 
    • leave the notes outstanding and wait for another conversion event to trigger.
       

When one of these conversion events occur, these early seed investors can convert the amount they are owed (both principal and interest) into the equity being offered to later investors (or even a purchaser of your company), but at a price lower than what those later investors will pay. In short, seed investors may have been offered a certain interest rate on their “loan,” but what they are really looking for is you to grow the company and make it more valuable. Then, those early seed investors stand to make even more from their investment by converting up to whatever deal is offered to later investors but at a discount that makes the risk of investing in such an early stage startup worth considering. This “discount” that will be applied to seed investors converting to equity is known as the discount rate. Convertible notes may also contain a valuation cap which is just a way of ensuring early seed investors have the opportunity to own at least a certain percentage of the company after the note is converted. 

While they might be offered to friends and family investors, convertible notes are still “securities” under federal securities law. Therefore, it is incredibly important that as the founder, you understand the legal risks. Our business attorneys can work with your business to make sure you comply with both federal and state securities laws when offering convertible notes to potential investors. We can also help you evaluate the differences between convertible notes, SAFEs, or simply offering seed investors equity in your company.