Convertible Notes
Illinois Convertible Notes Attorney
When looking for seed funding for your startup or wanting to invest in a business opportunity, you may want to use a Convertible Note, also known as convertible promissory notes, instead of immediately sharing equity.
Convertible notes get their name from the fact that an investor’s contribution starts as a loan and then converts into equity in a company upon a trigger or date. This gives some security to the investors in case the business does succeed.
Since convertible notes are securities, they must be registered under the Securities Act or qualify for an exemption from registration.
They are debt securities that have the following key terms:
- Principal amounts due at a maturity date.
- A fixed rate at which interest accrues on the principal balance.
- A claim on the company’s assets that is senior to all equity-holders and typically equal with all other unsecured non-senior debt.
Our Chicago area business law attorneys at Motiva Business Law help company founders and entrepreneurs effectively assess the terms of the agreement, identify potential risks, and negotiate favorable terms that align with their investment objectives.
We serve businesses in Oak Brook, Burr Ridge, Naperville, Hinsdale, Lombard, Addison, Downers Grove, Oak Park, Darien, Chicago, Lisle, Westmont, Willowbrook, Clarendon Hills, and the Chicagoland Area.
Motiva Business Law Offers
- Convertible notes
- SAFE Agreements
- Shareholders Agreement
- Corporate Bylaws
- Operating Agreements
How do Convertible Notes Work?
With startups, investors want to decrease their risk by being able to recoup some losses if a new company fails. By starting as a loan, versus an investment, investors sue on the terms of the promissory note. Company founders like this too because once they can show some success, their risk shifts when the investor’s loan turns into an investment.
The key stages of a convertible note financing include:
- Term sheet stage
- Diligence and financing document stage
- Closing stage
- Post closing stage
It is important for investors to conduct their due diligence above and negotiate terms that decrease their risk when investing in a company.
Convertible note terms to look out for:
To protect your interests, our attorneys will ensure to make an in-depth analysis of the following clauses:
- The maximum amount a company expects to raise
- Discount rate: Typically expressed as a percentage, an investor can benefit from purchasing shares at a lower cost than new investors during a future priced round.
- Maturity rate
- Interest rate and type (simple vs compound)
- Investment amount: Indicates how much money the venture capitalist will inject into the startup business.
- Discount: For example, if the SAFE includes a 20% discount and the new investors purchase shares at $10, the SAFE holder would convert their investment at $8 per share.
- Valuation cap: Designed to ensure the investor converts their investment into equity at a favorable price, a valuation cap sets a maximum pre-money valuation at which the investment converts into equity during the future financing round.
- Conversion trigger: The event that will cause the loan to convert into equity.
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Considerations Before SIGNING ON A CONVERTIBLE NOTE
Before entering into a Convertible Note agreement, ensure to have the legal and accounting support to either protect your startup or your investment. The following are some of the best considerations you should keep in mind:
- Investor starts as creditor: With a convertible note, the risk of losing an investment is decreased by classifying the investor as a creditor first. Founders should keep this in mind as the raise funds.
- Convertible Notes are subject to triggering events: You will receive a future equity stake based on the amount you invested only if the specified conversion trigger event occurs. Sometimes, convertible notes may not be triggered.
- Understand your rights: Ensure to know how a loan converts into equity and how many shares an investor will receive according to the investment, and what happens to a capital if the company dissolves.
How can our Illinois Business law attorneys help you?
Whether you are a startup or an investor, it’s of the utmost importance that you receive legal advice before entering into a Convertible Note Agreement. With the writing, review, or negotiation of a convertible note, a business contract lawyer will help you:
- Ensure that the convertible note is the best funding option for the startup business.
- If you are an investor, our business lawyers will help you do your due diligence before choosing to invest.
- Understand the implications of the agreement and protect your rights.
- Negotiate the most favorable terms regarding valuation caps, discount rates, and conversion mechanics.
- Mitigate the risks of entering the agreement.
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Convertible note FAQ
Yes, and are subject to the Securities Act. Founding companies should make sure they are compliant.
Both SAFE Agreements and convertible notes are convertible instruments, which means that they convert capital into equity at a specific time. However, convertible notes are considered debt, which means they come with an interest rate and expiration date. Also, convertible notes typically convert into equity after raising a specific amount of capital in a priced round.
Pros
- Attractive to investors: Protected by the valuation cap. security instrument, or conversion discount, investors may be more willing to take a risk on your company.
- No valuation is needed. A startup can start raising funds before getting a formal valuation.
Cons
- Uncertainty: Future valuations may not meet the SAFE investors’ expectations, and they may feel they’ve overpaid if the appraisal is lower than anticipated at the conversion event.
- No equity stakes: A convertible note investor does not have the rights of a stockholder until the specified triggering event occurs, which means the remedy is limited to the terms of the convertible note, and they typically do not have voting rights or control over the company until the conversion occurs.
- Dilution: As a result of the issuance of additional shares in future priced rounds, existing shareholders risk the reduction of ownership.