Contact Us Today 1-888-585-4093

Information & Insights

Early Stage Investing Guide: Convertible Instruments

Posted by Eric M. Leander | Jan 31, 2024 | 0 Comments

This article aims to provide a brief overview and explanation of the key documents involved in a fundraising scenario where investors are acquiring convertible debt instruments in exchange for investment capital.  In contrast to stock transactions, convertible instrument investments do not introduce new stockholders to the issuers cap-table until the instrument subsequently converts into equity as a result of one or more triggering circumstances. While there are other flavors of convertible instruments (SAFEs for example), this article will focus on convertible debt / convertible notes.

Generally speaking, In convertible instrument transactions there is a relatively limited set of deal documents compared to stock deals. For clarity, we categorize them into Commonly Used and Occasionally Used. It's essential to note that the discussion here generally outlines where concepts are typically addressed; however, each deal is unique, and specific issues may be covered in different documents.

When and Why are Convertible Instruments Used to Finance Growth

Convertible notes (and convertible instruments generally) are frequently employed in early-stage investing due to their flexibility and adaptability to the uncertainties surrounding a startup's valuation. In the early stages, determining a precise valuation for a fledgling company can be challenging, as it may lack a proven track record or established revenue streams.

Convertible notes provide a convenient solution by deferring the formal valuation until a later date, usually during a subsequent funding round or when the company achieves specific milestones. Investors and entrepreneurs often opt for convertible notes to bridge the funding gap, allowing the startup to secure necessary capital without the immediate need for setting a valuation or determining concrete deal terms. This approach enables both parties to focus on the company's growth and development, fostering a more straightforward and expedited investment process.

In addition, convertible debt in particular allows the investor to receive the time-value of their money by attaching an interest rate to the principal amount invested.  This interest generally accrues and converts into additional equity along with the principal; however, it can be structured as payable upon conversion (though the investor triggering the conversion most likely will require the interest to convert).

Commonly Used Deal Documents in Convertible Debt Deals

Term Sheet:  The initiation of most investment transactions involves, or is accompanied by, a "term sheet" – a document that outlines the key terms of the transaction.  Unless explicitly declared to have legally binding sections, term sheets in early-stage investments do not constitute legally binding agreements. Instead, they function as a set of notes summarizing the fundamental aspects of the deal, as mutually agreed upon during negotiations.

Term sheets serve as a foundation for attracting interest from potential investors and act as a reference guide for legal counsel in the creation of the final, legally binding documents.  Generally speaking, the goal with a term sheet is to capture as many of the deal-specific terms and to "put a fence around" the transaction. While later-stage term sheets can be exceedingly complex, convertible instrument term sheets tend to be simpler and shorter; focusing mainly on the economic terms and conversion mechanics of the intended note.

Convertible (Debt) Instrument: The Promissory Note, also known as the Convertible Promissory Note, functions as the actual debt instrument in the deal, resembling a sophisticated I.O.U. It includes details such as the borrower's name, date of issuance, principal debt (investment) amount, interest rate, interest rate calculation method (simple / compounding, annual / quarterly etc.), and the maturity date. Following these terms, there is typically a discussion of any negotiated cap on the conversion price or discount against the conversion price if applicable. 

Typically, once the base terms are set, the more specialized terms are dealt with such as:

  • Discount to financing round triggering conversion (usually b/w 15-20%).
  • Conversion mechanisms / triggers (e.g. Qualified Financing, Maturity, Voluntary)
    • Qualified Financing conversion requires a subsequent investment transaction meeting agreed upon criteria to trigger conversion of the note into the securities issued in the Qualified Financing at a readily determinable price (i.e. Discount or Valuation Cap).
    • Maturity Conversion contemplates that the note itself will not actually be paid back and will, instead, convert to equity in all events.  Typically, conversion at maturity is triggered at some type of "penalty" rate (e.g. Discount applied to Valuation Cap or other).
    • Voluntary Conversion allows the note holder to convert into equity at any point.  Typically, this is paired with any early / pre-payment option of the Company so that if the Company wants to repay the note, but the investor wants the equity, they can force the conversion.  This conversion is typically at or above any agreed upon Valuation Cap.

The note itself will establish the various mechanics of converting the principal (and likely the interest) into stock. What constitutes a "Qualified Financing" will / should be clearly defined.  As noted above, if there is no Maturity Conversion, the note should contain language relating to what happens in the event no Qualified Financing occurs before the maturity date. The note will often also contain additional language regarding the treatment of the note in the event of an M&A or other liquidity event prior to the maturity date / conversion.

Special Terms: Subordination, Security Interests, and Guarantees:  Some notes may also incorporate subordination, security interests, or guarantees, though these are not common in investor convertible debt.  Subordination establishes that the lender / investor agrees to be placed in lower priority in repayment compared to one or more other lenders. Security interests grant the rights to seize collateral in case of default, resulting in a secured note. Guarantees are personal commitments to repay the corporation's debt if it defaults. These features are more typical in classic bank-type debt; while they may occasionally appear in investor convertible notes, as noted above, it's exceedingly rare.

Note Purchase Agreement / Subscription Agreement:  The Note Purchase Agreement and/or Subscription Agreement, is the actual sale document for the investment instrument.  It outlines closing mechanics, includes representations and warranties from the company and note holders, and, in rare cases, may cover provisions found in a Note Holders Agreement or Voting Agreement.

Sometimes the Note Purchase Agreement / Subscription Agreement will be used to separate complex terms from the note itself, creating a two-part convertible debt deal. While this approach simplifies the Promissory Note itself, and provides a more comprehensive treatment of conversion mechanics in a traditional contract format, it results in a scenario where the investment terms reside in separate documents and must be read in conjunction to fully understand the rights and obligations of the parties.  Generally, we prefer all of the core terms within the Convertible Promissory Note itself (e.g. conversion mechanics, discounts, valuation cap / floor, maturity, pre-payment, default et. al.).

Occasionally / Rarely Used Deal Documents in Convertible Debt Deals

Note Holders Agreements and Voting Agreements: In some cases, note holders may insist on provisions typically associated with stock deals, such as board seats, information rights, and covenants. These agreements are often documented separately and titled as Note Holders' Agreement or Voting Agreement.  However, such arrangements are rarely established if at all.  Early-stage investors shouldn't generally expect to obtain more than board observer rights; to the extent they bargain for any greater influence or rights, most of these should be expected to be stripped away by subsequent qualified investors.

Subordination Agreements A stand-alone agreement may be used for subordination of debt, especially when new debt is introduced after existing debt is in place. This occurs, for instance, when an outstanding convertible debt round is in progress, and a new agreement clarifies the subordination of the old debt to the new debt.  Typically, convertible notes are considered unsecured debt; and both the note itself and sale document will include provisions expressly stating the same.  Adding a subordination provision into the investment documents themselves would obviate the need for a separate Subordination Agreement (unless the senior lender demands it as part of their financing). 

Warrant to Purchase Stock: To address concerns about convertible notes in the early stage context, warrants to purchase shares are sometimes offered in addition to or in lieu of caps and discounts.  Warrants and stock options are essentially the same; the distinction between the two is primarily in the context in which they are used (e.g. 'insiders' get options / 'outsiders' get warrants). Both represent a contractual right to purchase a specific quantity of stock at a pre-determined price in the future. Effectively, both warrants and options are a pure upside play with no downside risk prior to exercise

While these align the note more closely with equity, they introduce complexity into what is otherwise meant to be a more simple and straightforward transaction. To the extent warrants are requested, there are particular issues and counters that companies should consider before agreeing to issue them as part of an early-stage financing.

If you are considering raising or investing capital in a convertible instrument financing, reach out to a qualified attorney at Leander Group PLLC where business is personal.

https://www.newyorkbusinesslaw.com/contact-us

1-888-585-4093

About the Author

Eric M. Leander

Principal Attorney Eric Leander focuses his practice on business, corporate, securities, commercial real estate, contracts, and transactional law matters, representing established businesses, innovative entrepreneurs, high-growth startups, and investors across a variety of industries throughout New York State and beyond.

Comments

There are no comments for this post. Be the first and Add your Comment below.

Leave a Comment

GET IN TOUCH

Trusted Representation

We are a full service Business Law firm - we are waiting for your call, and are happy to assist with your business legal needs.

Eric Michael LeanderReviewsout of 8 reviews

Menu