Convertible notes are a popular form of early stage financing. A convertible note is a debt instrument that may convert into equity sometime in the future, typically upon the occurrence of certain events (such as a preferred stock financing or a change in control). Convertible promissory notes are favored by startups (referred to as the “issuer” in the context of a convertible notes financing) and early stage investors alike because (1) it is not necessary to decide on a valuation of the issuer in connection with the note financing and (2) the legal documentation required for a notes financing is relatively sparse (as compared to a priced equity financing), which reduces the transaction costs of the financing.
The basics of convertible promissory notes are well covered by others in the legal blogosphere (Yokum Taku does a nice job here
, though his post is a bit out of date at this point). We here at the VLD handle early stage financings on a regular basis, so we encounter many forms of convertible promissory notes “in the wild.” There are a few “wrinkles” to the convertible promissory note that we have encountered in the past few months that we think merit discussion.
1. Period of the offering. Usually a convertible promissory note is sold pursuant to a note purchase agreement. The purchase agreement typically provides that the notes can be sold for a set period of time, usually 30 to 90 days from the date of the note purchase agreement. However, because startups often take more time than expected to identify potential investors and sell notes, this provision is often amended, often multiple times, to extend the time period in which notes may be sold.
Here at the VLD we have seen a few purchase agreements recently that allow notes to be sold any time until the first preferred stock financing of the issuer. This makes amendments to the purchase agreement extending the amount of time in which notes may be sold unnecessary. The drawback of this type of a provision is that it may disadvantage early investors in the notes financing. From the early investors’ perspective it may seem unfair that they invest money in the issuer on “day one,” when its prospects are most uncertain, while another investor could wait for six months or more, perhaps until the issuer’s business prospects are more concrete, to invest on the same terms as the early investor.
2. Termination of interest accrual upon a change in control. A convertible promissory note, like any other debt instrument, accrues interest over time. Upon conversion of the note, this interest converts into equity in the issuer along with the principal amount of the note. We have seen a few convertible notes recently that provide that interest stops accruing on the note at a set time some number of days prior to the signing of a definitive agreement with respect to a change in control of the issuer. From an administrative perspective, this is very helpful when handling an acquisition of the issuer, because the closing date of an acquisition is sometimes a moving target, and recalculating accrued interest, and thus the number of shares that notes convert into, can cause a “rejiggering” of a range of closing calculations that can be administratively problematic.
Two potential issues with respect to this termination of interest accrual give us pause. First, there may be a fairly lengthy amount of time between the signing of a definitive agreement and the closing of a transaction, so an investor may be giving up a significant amount of accrued interest by agreeing to this early termination of interest accrual. Second, it remains an open question in our minds as to whether the IRS would tax the investor on the amount of imputed interest during the period between the termination of interest accrual and the closing of the change in control transaction.
3. Automatic conversion upon maturity. In its traditional format, a convertible promissory note has a maturity date on which the note must be repaid. This was traditionally viewed as a way for the investors to have leverage over the issuer – startups typically don’t have cash on hand to repay notes once they mature, so they need to keep their notes investors satisfied with the progress of the business in order to induce the investors to agree to extensions of the notes maturity dates (until the first preferred stock financing or other conversion event).
However, as “lean launch” methods have gained favor, some startups may actually become mature enough businesses to either (1) generate profits or (2) obtain traditional bank financing sufficient to repay the notes when they come due. This is a terrible outcome for the early investors, as they merely get repaid the principal and interest on their notes when they should be receiving a hefty equity stake in a now-profitable business. The response to this potential bad outcome has been a provision for automatic conversion upon maturity of the notes (typically at the conversion price cap).
A downside to this automatic conversion at maturity of the notes is that the investors lose their leverage over the issuer when it comes time to extend the maturity dates of the notes. Another downside is that this type of provision typically states that the notes convert into the most recent form of preferred stock issued by the issuer, or if no preferred stock has been issued, the notes convert into common stock of the issuer. Consequently, the issuer may prefer that the notes mature and convert into equity in the issuer if there has not yet been a preferred stock financing, because it would mean that the notes investors have their notes converted into common stock in the issuer, rather than preferred stock that typically has a liquidation preference, anti-dilution protections, and other rights and privileges.
As always, we here at the VLD are happy to discuss these issues, and all of the other permutations of convertible promissory notes and early stage financings, with entrepreneurs and early stage investors alike.