What are the consequences of using a convertible note instead of a conventional promissory note to borrow money for your company?
Convertible notes are promissory notes with a secondary business purpose other than debt representation. Convertible notes have all of the features of a standard promissory note, such as an interest rate and a security promise (if applicable).
The difference is that under a convertible note, the lender (also known as the creditor or holder) has the option to convert all or part of the outstanding debt into the corporation's shares in specific situations
When Would I Use a Convertible Promissory Note?
It is commonplace for corporations to use convertible notes in business dealings. Here are a few likely scenarios:
A convertible note, like a conventional promissory note, must deal with the question of prepayment. Having the option of making prepayments without penalty is usually in the best interests of the company. However, as with any loan, prepayment would prohibit the lender from getting the agreed-upon future interest payments. Furthermore, in the case of a convertible note, a lender may refuse to accept prepayment if it believes the firm has potential and would prefer to keep its options open to become a future stakeholder. Prepayment is a topic that must be discussed between the lender and the company, and it must always be addressed in the convertible note's terms.
Treatment of the Note
For accounting purposes, the outstanding balance of the loan is classified as debt, not equity, until the lender converts the note into company stock. This means that the lender normally has no stockholder rights, such as voting rights, distribution rights, and so on, until the note is converted.
Triggers for Conversion
The terms of the convertible note can provide that the loan is converted into stock based on a variety of triggering events, which can include the following:
The ability of the holder to convert the note into business equity is a significant issue that the company (as borrower) and the holder must carefully consider. Given that stock ownership is typically the primary means for a party to exert control over company management while also earning a profit, the holder will desire as much flexibility as possible when it comes to conversion circumstances. Similarly, the borrower will want to get as many conversion delays and/or constraints as feasible.
Note that in the event of a liquidation, debt holders receive priority over equity holders in the distribution of remaining cash and assets, posing a danger to the creditor. As a result, if the debt is converted into stock, the holder will lose priority if the company is dissolved or declares bankruptcy.
Methods of Conversion
The next stage is to determine how many shares the debt is convertible into when the holder initiates a conversion. This is obviously important not only to the lender, but also to the remaining stockholders, who want to be as diluted as possible. In the calculation of outstanding debt, all methods of conversion commonly include accumulated and unpaid interest. The type of stock into which the note is convertible (whether common stock or a series of preferred stock) must also be agreed between the lender and the corporation. Keep in mind that the computations below may not always result in complete numbers of shares being issued to the lender, resulting in fractional shares. The convertible note's terms should state whether fractional shares should be rounded up to the next whole share or treated differently.
The following are various options for calculating the conversion of outstanding debt into shares of the corporation:
Adjustments for Stock Splits or Recapitalization
Note that the terms of the convertible note, including those for conversion, should be subject to change in the event of stock combinations, stock splits, or recapitalizations, unless doing so would be detrimental to the firm (as the borrower) or you (as a potential lender).
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