Using Convertible Promissory Notes to Finance a Startup

Jonathan Friedman discusses how convertible promissory notes often provide a fast and cheap way for start-up companies to raise capital.  However, before raising capital through the issuance of promissory notes, companies need to evaluate the potential impact of convertible debt on the company’s future capital structure, and investors need to evaluate whether a straight equity investment is preferable to the purchase of debt.  Jonathan’s practice focuses on venture capital and corporate finance, intellectual property licensing, mergers and acquisitions, securities law and general corporate and business matters. Jonathan has represented corporations and other entities in a wide variety of industries, including Internet and e-commerce, apparel, medical devices, entertainment and high technology.

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What is a convertible promissory note? 

A convertible promissory note is a debt instrument that is convertible into equity at a future date either automatically upon the occurrence of certain events or at the choice of the investor.  Even though it is a debt instrument, investors who purchase convertible promissory notes issued by a start-up company are expecting the notes to convert into equity at a future date, since equity (unlike straight debt) allows investors to participate in the upside of the company.  A simple return of principal and interest is not attractive to an early stage investor who is taking tremendous risk in funding a start-up.  To compensate investors for the risk they are taking, the notes sold are often convertible at a discount to the price of the next preferred equity round and will also contain a “cap” – or a maximum conversion price – on the price at which the note will later convert.

What is preferred stock?

Preferred stock is an equity ownership interest in a company with certain features that are designed to protect an investor’s investment.  For example, investors in preferred stock typically receive cash distributions before holders of common stock and also receive certain rights relating to the control of the company, such as board representation and the right to veto certain company activities.

Why do start-up companies and investors sometimes prefer the sale of convertible promissory notes over equity to finance a startup?

Convertible promissory notes are sometimes used to finance start-up companies when the prospective investors lack the sophistication to properly price an equity round, when the size of the financing does not warrant the costs of a traditional preferred stock financing or when the company and the investors want to avoid pricing an equity round.  In addition, convertible note financings are often used because they are perceived to be quicker and cheaper to structure and document than preferred stock financings.

What are some of the risks for investors financing a start-up through a convertible promissory note?

Even though convertible notes often contain price discounts to the next equity round and conversion caps, purchasers of convertible notes are often not sufficiently compensated for the risk they are taking in financing a start-up.  Caps are often set at a premium to the company’s value at the time the notes are issued and discounts may not be adequate, especially as the time between the issuance of the notes and the priced equity round increases.  Moreover, initial investors are subject to the risk that later investors, who often have greater bargaining power (especially if a company is in dire need of financing), will attempt to renegotiate the terms of the promissory notes to their detriment.

Convertible notes also may not adequately compensate early stage investors to the extent the investors provide resources to the company, such as key customer or supplier introductions, or otherwise add credibility or other value to the company.  If the value of the company rises substantially as a result of the investor’s efforts, the investor is ultimately increasing the price they will pay for their own equity in the company, which is clearly a perverse outcome.

What are some of the risks a company that issues convertible promissory notes faces?

Convertible notes work well for start-up companies when the value of the company increases between the time of the debt financing and a preferred stock financing.  However, if the value of the company falls, investors who purchased convertible notes may end up owning more equity in the company then the company anticipated at the time of the debt financing.  This occurs because the price discount feature often included in the notes enables the investors to purchase equity at a price below what they would have paid at the time they purchased the convertible notes.  Moreover, because the purchased equity often contains a liquidation preference, in addition to obtaining a larger equity position in the company at the expense of the founders, investors will also likely obtain an increased preference over the founders to the cash of the company in the event of a sale, dissolution or winding up of the company.  Another downside of convertible notes is that, in the event a convertible note is not converted into equity prior to its maturity, investors could demand that the note is repaid with principal and interest, or potentially force the company into bankruptcy if the loans cannot be restructured.

Conclusions

The issuance of convertible promissory notes can be an effective means for start-up companies to raise capital.  However, before raising capital through the issuance of promissory notes, investors and companies need to carefully evaluate the risks associated with the issuance of promissory notes in comparison to other financing alternatives.

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For more information regarding promissory notes, raising capital, or similar inquiries, please contact Jonathan Friedman at (818) 444-4514 or jfriedman@stubbsalderton.com.