Basics Of Convertible Note Financings

Convertible notes are a common structure for private company financings, most often for early stage companies trying to raise $1 million or less (see “Your First Vehicle for Fund Raising:  Convertible Notes or Preferred Stock”).  Below is a summary of the types of terms for such financings, and a quick primer on what to look out for if you’re considering this type of funding.

1.  Basic Terms.  Convertible notes, also called “bridge loans,” are loans provided to a company that will be converted to stock at some specified future event.  The notes bear interest — typically 5-10% — and will generally be converted on the same terms as principal.  Notes will have some repayment date, ranging from as short as a few months to three or more years.  Most often they fall in the 12-18 month range. Beyond that the holders can demand repayment of interest and principal.

2.  Automatic Conversion.  The classic convertible note automatically converts into the “next” round of equity financing of the company. This is a risk for both the company and the investors since neither party knows the price or terms of the company’s next financing.  As an example, if the note is a “bridge” between a company’s Series B Preferred Stock financing and its anticipated Series C financing, the note would be drafted so that principal and interest convert automatically if and when the company closes the Series C round. There are usually some parameters that forecast what that next financing round might looks like.  Investors may ask that the financing include at least a minimum amount of proceeds from new investors or for a cap on the price of the shares into which the notes convert.

3.  Other Types of Conversion.  Many bridge loans anticipate other types of optional conversions.  For example, if the company is sold before the next financing, do the notes convert into common stock or an existing class of preferred stock?  Similar questions arise if the notes do not convert before they become due, or if the company undertakes an IPO before repayment or conversion.

4.  Discounts or Warrant Coverage.  Interest alone is almost never the sole benefit offered to note investors.  Often they will also receive either a discount on the conversion price — ranging from 10-25% — or warrants.  Warrant “coverage” is generally expressed as a percentage of principal. Twenty percent warrant coverage on a $1-million note financing means that in addition to conversion of principal and interest, investors would receive warrants to purchase an additional $200,000 of the type of securities issued upon conversion of the notes.  Investors should not receive both a discount and warrant coverage.

There are of course many other details and issues involved in convertible note financings — whether the notes are secured by the assets of the company, whether they are issued under a purchase agreement where the company makes a number of representations and warranties, whether they can be amended by a majority vote of investors or only with unanimity, and whether the company will pay for legal counsel for the investors, just to name a few. As always companies and investors should proceed carefully and with sophisticated counsel when considering this type of investment structure.