What Is a Convertible Promissory Note?

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:

• You've found a lender willing to lend money to your company, and because the lender believes in the company's future success, it wants the opportunity to convert the outstanding debt into stock, exercise its shareholder rights, and share in any future upside.
  
• Your firm has an existing loan, and while it is expanding, it still lacks the liquidity to make loan repayments on time, if at all (in other words, the company is in payment default). In certain situations, the lender may choose to negotiate with the company to replace the existing note with a convertible note, which would allow the lender to become a stockholder with more direct control over the company's management.
  
• You need to personally loan more money to the firm as the owner/majority stockholder, and you want that debt recorded in an agreement between you and the company. A convertible note would be a better alternative in this scenario than a conventional promissory note since it would allow you to convert the debt into more stock, increasing your stake in the company. Always contact your accountant or tax counsel before providing money to the company, whether in the form of a convertible note or otherwise.
  

Prepayment

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:

• Upon an event of default by the company (such as nonpayment of principal or interest, bankruptcy, liquidation, or a sale of the company).
  
• Automatically on the maturity date of the loan, assuming that the loan has not yet been paid in full. In such cases, the note would be converted to stock based on the outstanding balance of principal and interest under the loan.
  
• The lender's delivery of a conversion notice to the company at any time, for any reason.
  
• Upon the company's achievement of a specified dollar valuation stated the terms of the note.
  
• Upon the sale of the company to a third party resulting in a new majority shareholder.
  

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:

• The most straightforward technique is to set a predefined price per share (typically reduced in favor of the lender) that will be used to determine how many shares the holder should get depending on the existing debt.
  
• The shares can be converted using a predetermined formula that takes into consideration the company's valuation on the date of the conversion notice, the actual conversion date, or any other date agreed upon by the parties.
  
• In the event that the firm is sold, the shares can be converted using a specified formula that takes into consideration the buyer's offer price per share (calculated at a discount to the lender). Keep in mind that in this case, the buyer will have gone over the terms of the convertible note as part of its due diligence and will be aware of the company's requirement to issue extra shares to the lender as part of the acquisition. This could be a deal breaker for potential purchasers. In any case, disclosing the details of the convertible note to the buyer as long ahead of the sale as practicable is always a good faith practice. Otherwise, the buyer's ignorance of this issue could have negative ramifications for the selling shareholders or the transaction's overall sustainability.
  

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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