Convertible Notes in Startup Fundraising

In the startup ecosystem, raising capital is a pivotal moment that can define the trajectory of a business. Among the many options available for securing funds, convertible notes have emerged as a genuine alternative for both startups and investors. This instrument, is essentially a loan that can be converted into equity, presents a blend of flexibility, efficiency, and strategic advantage.  

Allied Legal's commercial lawyers regularly assist startups and founders with navigating convertible notes. Connect with our commercial lawyers today.

The Essence of Convertible Notes

Convertible notes are a type of debt instrument that offer investors the option to convert their outstanding loan into shares in the company on the occurrence of specific trigger events. This mechanism provides a safety net for investors, allowing them to either reclaim their loan with interest or convert it into shares, potentially at a lower price than the market value.

The attractiveness of convertible notes lies in their simplicity and speed, eliminating the immediate need for a company valuation and the complexities of equity investment. However, it's crucial to navigate the implications of future share conversion carefully.

Impact On the Cap Table

The cap table is significantly impacted by convertible notes. They convert into shares upon specific events, such as a qualifying financing round, maturity date, or an exit event. Before conversion, investors hold a note-holder status; after conversion, they become shareholders. Planning and transparency are crucial in managing the dilutive effects of such conversions on existing shareholders.

Conversion Triggers and Processes

Maturity Date: If no qualifying financing or exit event occurs by the maturity date, note-holders may choose to convert their loan (plus interest) into shares. The conversion rate and share class are predetermined, often favouring the issuance of a higher class of shares to note-holders.

Qualifying Financing: This automatic conversion is triggered by a new equity investment round. Companies must issue a conversion notice to note-holders, detailing the share quantity and calculation method. The terms may include discounts or valuation caps, influencing the conversion share price and the number of shares issued.

Exit Event: Before an exit event, note-holders decide between cash recovery or conversion into shares. The terms set the conversion rate, often at a discounted share price, adjusted for valuation caps if present. This ensures noteholders partake in the exit benefits similarly to ordinary shareholders.

Issuance of Shares Upon Conversion

Converting convertible notes into shares requires a series of formal steps:

1. Board resolution and possibly shareholder approval for share issuance.
2. Adherence to shareholder agreements or deeds of access.
3. Updating the company's registers for members and note-holders.
4. Issuing share certificates to new shareholders and notifying regulatory bodies.

Key Takeaways for Startups

Utilising convertible notes for fundraising demands a thorough understanding of their potential impact on your company's future. Consideration of the trigger events, the calculation of share issuance, the influence of accrued interest, and the adjustments to the company's cap table are paramount. Equally important is the procedural adherence required to effectuate the conversion smoothly.

Convertible notes, while offering a streamlined path to funding, necessitate careful planning and communication with investors to align interests and expectations. By mastering these elements, startups can leverage convertible notes as a powerful tool in their capital-raising arsenal, paving the way for sustainable growth and success.

Connect with Allied Legal's Commercial Lawyers

Speak to Allied Legal's commercial lawyers today should you seek assistance.  

Connect with us at Allied Legal on 03 8691 3111 or drop us an email at hello@alliedlegal.com.au to discuss how convertible notes could benefit your startup.

^{The insights presented in this article are derived from ‘What happens when Convertible Notes convert?’ written by Sophie Mao and published to Mondaq on 25 October 2022.}