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Financing Your Start-Up Using Convertible Notes 


Need to raise money for your start-up?
Have you considered using Convertible Notes?
   

Convertible notes, if well structured, can be a simple, flexible and cost-effective way for a start-up to raise funds.  Start-ups can offer convertible notes, which are debt instruments that may be converted to equity, to raise capital, instead of offering shares to investors at the very outset.  

The convertible note agreement would set out (among other things):  

  • The amount to be invested via the issue of convertible notes.
  • Whether interest is to apply (and the relevant interest rate).
  • Trigger events for conversion.
  • Other general rights attaching to the notes.
  • Whether note holders will be granted security while the debt remains outstanding. 
  • How the company will be valued at the time of conversion. 
  • The discount rate applicable on conversion (i.e. noteholders are usually offered shares at a rate which exceeds the company’s market valuation at the time of conversion).  The discount rewards the noteholder for taking the risk of investing in the company at the very early stages.  Generally, the discount rate ranges between 10% – 40%.

Broadly speaking, if a trigger event occurs, noteholders receive shares in company in exchange for their convertible notes.  The convertible notes are then cancelled (i.e. the company will no longer owe a debt to noteholders upon conversion to shares).   

Benefits  

  1. For the noteholder

While the advantages for noteholders will depend on the terms negotiated, the below sets out some of the general benefits of investing through convertible notes: 

  • The notes may attract interest giving the founders a source of ongoing revenue. 
  • The interest rate applied may be more favourable compared to dividends paid to shareholders.
  • The notes may rank ranking more highly compared to certain classes of shares.
  • Noteholders may have the flexibility of having the notes repaid or converting the notes to shares in the future.
  • In the event of liquidation, secured convertible notes may have higher priority over other creditors.

 B. For the company

From a start-up company’s perspective, convertible notes provide the opportunity to raise funds without having to immediately part way with equity.  This can be advantageous because investors holding convertible notes will also generally have less control over the decision making of the company compared to shareholders.  Founders also do not have to deal with the problem of valuing the company in its very early stages of operation.  The start-up is able to receive funding when its needs it most by issuing notes to investors and shares are issued pursuant to a trigger event which is likely to be at a time when the company is up and running and has potentially increased in value (i.e. founders are likely to be able to negotiate a more favourable rate at which shares are issued when compared to the very early stages of the company’s life).  

  Drawbacks  

  1. For the Noteholder

Some investors may consider convertible notes a high-risk proposition compared to investing pursuant to a priced equity round by which time the company will have some track record in terms of its operating history.

     B. For the company 

Founders must remember that convertible notes are effectively a loan that must be repaid (either by repaying the debt or converting notes into shares). 
 
In the early stages of a company’s existence, funding is hard to source.  Investors can look to take advantage of this by seeking terms which are highly favourable to them.  Start-ups need to be aware of this and not risk entering into overly rigorous arrangements.


Contact Allied Legal
 

Understanding whether issuing convertible notes to raise capital is the best way forward for your start-up is vital. Allied Legal’s lawyers can help guide you through the process and advice you on these and other issues.  We provide complimentary 30-minute initial consultations to help understand your needs.  Please contact us when you are ready to seek specialist advice: http://alliedlegal.com.au/contact/    

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