Convertible notes are promissory notes that serve an additional business purpose other than merely representing debt. Convertible notes include all of the terms of a vanilla promissory note, such as an interest rate and the pledge of underlying security (if applicable). See Understanding Promissory Notes for Small Businesses and Promissory Note for discussions regarding standard promissory notes, together with related forms.
The difference is that the lender under a convertible note (called the creditor or the holder) has a right, under certain circumstances, to convert all or a portion of the outstanding debt under the note into stock of the corporation.
It is commonplace for corporations to use convertible notes in business dealings. Here are a few likely scenarios:
As with a standard promissory note, a convertible note has to deal with the issue of prepayment. It is typically in the best interests of the company to have the option of making prepayments without penalty. However, as with any loan, prepayment would prevent the lender from receiving the future interest payments it had previously bargained for. Furthermore, in the context of a convertible note, sometimes a lender will resist prepayment because it sees promise in the company and would rather keep its options open to become a future stockholder. Prepayment is an issue that must be negotiated between the lender and the corporation, and it must always be clearly addressed in the terms of the convertible note.
Until the lender converts the note into company stock, the outstanding balance of the loan is treated as debt, not equity, for accounting purposes. This means that until the note is converted, the lender usually does not enjoy any stockholder rights, including voting rights, rights to distributions, and so forth.
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:
If and when the holder is able to convert the note into equity of the company is a critical issue that must be carefully negotiated between the company (as borrower) and the holder. Given that stock ownership is generally the primary vehicle for a party to exert control over company management and earn a return on investment, the holder will want to have as much flexibility as possible regarding the conversion conditions. Similarly, the borrower will want to negotiate for as many delays and/or limits on conversion as possible.
Note that the risk for the creditor upon conversion lies in the fact that, in the event of a liquidation, debtholders get priority over equityholders in the distribution of remaining cash and assets. As such, if the holder converts its debt into stock, it will have relinquished its priority position if the company is dissolved or declares bankruptcy.
Once the holder triggers a conversion, the next step is to figure out how many shares the debt is convertible into. Clearly, this is critical to not only the lender, but also the remaining shareholders, who want to be diluted as little as possible. All methods of conversion typically include accrued and unpaid interest in the calculation of outstanding debt. Also, the type of stock into which the note is convertible (whether it be common stock or a series of preferred stock) must be negotiated between the corporation and the lender. Furthermore, keep in mind that the calculations listed below might not always produce whole numbers of shares to be issued to the lender, resulting in fractional shares. The terms of the convertible note should specify whether or not fractional shares should be rounded up to the next whole share or treated some other way.
The following are various options for calculating the conversion of outstanding debt into shares of the corporation:
Note that the terms of the convertible note, including those for conversion, should be subject to adjustment for any stock combinations, stock splits, or recapitalizations, unless any such modifications would be against the interests of the company (as the borrower) or you (as a potential lender).