One of the most common hurdles in starting a business is a lack of capital. Most entrepreneurs make use of their own funds in the early days (so-called “bootstrapping”). As demands for capital increase with the growth of new companies, entrepreneurs often turn to their friends and family to fund their business activities. When these friends and family members invest in the business, they obviously expect something in return.

To illustrate this situation, we return to the Italian-restaurant hypothetical from an earlier post and suggest one popular investment alternative for this situation.

Following their graduation from hospitality school, Mary and Marty decided to open an Italian restaurant, M & M’s Pasta Delite, which they operated through their new limited liability company. In order to fund the initial activities of the business, Mary contributed $50,000 from her trust fund. Using this money, they were able to lease space for the restaurant and buy some equipment.

After opening their restaurant, Mary and Marty quickly realized that they could attract more customers during the COVID pandemic if they had an outdoor seating space. Neither Mary nor Marty had any savings that they could contribute to fund the expansion. At Marty’s family’s annual Labor Day barbeque (held outdoors with strict adherence to mask and social-distancing guidelines), he told his family about his idea to expand the restaurant initially and of further plans to franchise the restaurant. Marty’s Uncle Mo and Aunt Matilda were excited about the idea and each agreed to invest $25,000 in the business.  The obvious question was what would they get for their $25,000 investments (e.g., 10%, 20%, 30% of the company).

Uncle Mo, a successful investor in recent years after selling his own business, suggested that the company issue convertible notes.  Uncle Mo explained that the notes would provide the investors with minimum interest-based returns, but also allow the investors to share in the upside for the company if it became as successful as hoped. Mary and Marty liked this idea, and Marty contacted the Clinic for assistance in preparing the notes.

Convertible notes are essentially loans to the company. Investors lend money to the company and, in exchange, they receive convertible promissory notes. Upon the happening of a specified event prior to maturity, the notes typically convert automatically to equity, usually based on the valuation used for the specified event.  If none of the specified events occurs by the maturity date, the rights of the noteholder vary; e.g., the noteholder may have the option to convert the note into a specified level of equity or to demand repayment of the note along with any accrued interest.

One important point is that neither the company nor an investor expects a convertible note to be repaid in cash at maturity.  The bet is that before the maturity date there will be a significant event, such as a private placement of equity or a sale of the company, that triggers automatic conversion of the note or, in the case of a sale, repayment on an as if converted basis. It would be rare for any owner of an issuing company, such as Mary and Marty in our example, to guarantee personally the repayment of a convertible note.

Convertible notes are debt instruments, and, therefore, they do not afford the noteholders any ownership rights in the issuing company, but they do rank ahead of the equity owners in a liquidation. Investors do not receive voting rights, regardless of the size of their investment.

Another noteworthy instrument that has been gaining popularity as a fundraising tool is the SAFE (Simple Agreement for Future Equity).  As with a convertible note, a SAFE usually converts automatically to equity upon a future event, typically a future equity-funding round. A SAFE serves the same general purpose as a convertible note—raising funds without issuing equity right away. However, unlike convertible notes, SAFEs are not debt instruments and, therefore, do not accrue interest. For brevity, we will limit our discussion to convertible notes here.

One major reason why a new company may want to issue convertible notes instead of equity is that they allow the company to avoid a speculative valuation of the business at an early stage. Investors generally value mature companies based on their earnings or some other performance-based metric. In contrast, startups and early-stage companies often have no revenues, income or, sometimes, even salable products or services. This issue, coupled with the founders’ concern that their company’s future potential would not be adequately considered in the valuation process, makes valuing a young business a difficult task. However, because a company is simply borrowing funds with a convertible note, the valuation process can be deferred until there is a better basis for valuing the company.

Another upside of using convertible notes is that the process is fairly easy and inexpensive. In most cases, issuing convertible notes does not involve preparing a large volume of complicated documents, as would be the case with a typical private placement of equity. Further, convertible notes tend to have fewer terms (discussed below) than a new class of preferred securities, which investors often demand. This makes negotiating the terms of the note quicker and less contentious. These factors all contribute to the facility and cost-effectiveness of using convertible notes.

As mentioned above, convertible notes usually have only a few terms. We discuss the most common ones here.

1. Principal.

The principal amount, or face value, of a note is the amount invested by the investor.

2. Interest Rate.

This is the annual rate at which interest accrues on the note until it is converted to equity or repaid. This term is usually not hotly negotiated because earning interest is not an investor’s primary motivation when investing in an early-stage business. Investors care more about getting equity because they see the company’s potential.

3. Maturity.

The maturity date is the date on which the company must repay the principal plus the interest accrued on the note. The maturity date for convertible notes is generally between 18 and 24 months from when the notes were issued, although the company often requests an extension.

4. Conversion to equity.

This term is typically the most significant and, therefore, receives a great deal of attention from both, the issuers and the investors. The basic mechanism of conversion is that the principal amount of the notes (plus accrued interest, if any) automatically converts into shares of the issuing company.  A note could have one of several triggers for conversion of the notes. The most common triggering events are a subsequent round of equity funding and the maturity date.

5. Conversion Discount.

When a convertible note provides for conversion in connection with a later equity funding, the conversion is based on the valuation used for that equity sale. However, the conversion rate for a note usually benefits from a discount (often 20%) applied to the valuation for the equity sale. The rationale for this discount is the greater risk taken by the noteholder when investing earlier.

6. Repayment.

Traditionally, convertible notes are not repaid; instead, they convert into equity. However, if the note has not converted by the maturity date, the company probably does not (and will not) have the money to repay the debt. Rather than convert a note into equity that is illiquid, many noteholders choose to agree to extend the maturity date with the hope that the outlook for the company will improve.

The terms in this post are meant to illustrate basic provisions in convertible notes. The terms of a note may vary depending on the industry of the issuer, the sophistication of the parties, and the amount of capital to be raised, among other factors.

 

This post was written by Riya Anchi, a current third-year student at Penn State Law.