Broadly speaking, there are three major ways for a start-up company to generate money to keep its business growing.
- Generate revenue through the sale of its products or services, which can then be reinvested in the company.
- Issue equity interests to third-party investors who then become co-owners in the business.
- Borrow money by issuing debt securities to potential investors who then becomes a creditor of the start-up company.
While each of these approaches benefits and drawbacks, this post explores one common debt security called the convertible note.
What is a convertible note?
A convertible note is a type of debt security that companies often use to raise money in between rounds of equity financing. As with other forms of debt, convertible notes generally set forth a principal amount (the amount that the company borrows from the noteholder), an interest rate (which accrues on the outstanding loan amount) and a maturity date (a fixed time when the principal and interest on the convertible note must be repaid to the noteholder).
However, what distinguishes a convertible note from a run-of-the-mill loan is that convertible notes can also include a provision to convert the note's outstanding principal and interest into equity interest if specific events occur.
Instead of the company repaying cash to the noteholder, the company will repay the noteholder with equity in the company. Oftentimes, the note will be designed to automatically convert into equity in a company whenever that company next issues a series of stock or membership interests. Additionally, the convertible note may include a discounted conversion price that allows the noteholder to receive ownership interests in a company at a price lower as a "reward" for investing in the company early.
There are several advantages to issuing convertible notes, including the following:
- a relatively inexpensive way of raising capital;
- oftentimes the interest rate can be lower than transactions without a conversion option;
- the possibility of replacing debt with equity on the balance sheet can improve the issuer's leverage ratio;
- they do not generally restrict the issuer's activities or operations; and
- they can enable the issuer to raise immediate funds at a more appropriate price, especially if the issuer's stock is currently undervalued by the market.
Conversely, some drawbacks of convertible notes include:
- potential negative impact on the price of the company's stock if the market reacts negatively to a possible dilution in the ownership of the company;
- the added complexity of handling the tax and accounting issues associated with convertible notes; and
- the risk that if the company's stock price is less than the conversion price, noteholders may choose to not convert their convertible notes into equity and the company may need to raise additional funds to pay off the convertible notes at maturity.
Contact your lawyer if issuing convertible notes or pursuing another method for raising funds might be a good option to expand your business.