A convertible note is a type of business loan that comes with a specific date called the maturity date. When the maturity date arrives, it triggers one of two events. Either the note converts into preferred stock for the investor, or it does not. If the note fails to convert, the original principal and accrued interest are due.
This article will explain the life cycle of convertible notes from their inception to their maturity date so that you understand the legalities of each outcome and can best prepare yourself for an upcoming maturity date.
How Do Convertible Notes Work?
Many startup companies need capital but fail to meet the requirements of banks or other financial services.1 As a result, it is difficult to determine a fair pre-money valuation for the startup because there is no purchase price.
Convertible note investors step in to fill this void.
A convertible note, also known as a convertible bond or convertible debt, is a loan that converts into preferred stock shares of a business on or before its maturity date. Convertible notes may differ but generally have a few commonalities concerning length, interest rate, payments, and maturity date.
The convertible note investor and the company sign a debt agreement. There will be special convertible note terms relating to conversion, preferred stock, valuation cap, and preferred equity.2 The SEC makes a sample convertible note available for review.3
How Does the Maturity Date Work?
Most business investments are in exchange for a share of the company—stock purchases, for example. However, investors in a startup face the same problem as the bank—how does one determine the startup’s pre-money valuation? In addition to being complex and time-consuming, the pre-money valuation determination must be accurate for the investor and the company.
A convertible note sidesteps the difficult and time-consuming process of placing a value on a startup and allows the investor to give the company the capital it needs as a debt obligation.
On a future date, the maturity date, the note converts into ownership after an initial equity investment.
What Is the Typical Maturity Date for a Convertible Note?
Convertible notes are generally short-term notes, ranging from 18 to 36 months. These notes defer principal and interest during the life of the note.
The purpose of a convertible note is for a startup business to have a priced round of investment before the maturity date of the convertible note. At that time, the value of the note will convert into equity in the company at the same or a better price than the new investor’s price. This protects early investors and is done in accordance with the note’s Most Favored Nation clause.4
What Can You Do If Your Startup Is Nearing the Maturity Date?
As the maturity date approaches, the startup should know if it is in a position to seek qualified financing. If it is, the startup should begin recruiting investment at least six months before the maturity date. This will allow the notes to convert into equity.
If the business is unlikely to qualify for financing, approach the investor and discuss how to proceed.
What Happens on the Note’s Maturity Date?
When a convertible note reaches its maturity date, it will either convert, and the investor receives equity in the company, or it will not convert, and the principal and interest are due as debt.
What Happens When the Note Matures and Converts?
Generally, this indicates that everything worked as planned when you created the note. The noteholders will then become preferred equity holders.
When a note converts to equity, it happens in one of three ways: through a qualified capital round, automatic conversion, or a change of control.
Qualified Capital Round
Qualified financing is usually what the startup and the convertible note investors hoped would occur.
In short, the investor’s money gave the company time to grow. In exchange, the noteholders will receive equity at a discounted rate upon closing a Seed or Series A equity round.
Automatic conversion is rare. However, if the promissory note has an automatic conversion provision, then the note will automatically convert to equity on the note’s maturity date, which may mean to common stock.
More common is that the investors have the option (approval right) to convert to equity on the maturity date. A majority vote of the noteholders usually determines whether to exercise their approval rights.
Valid reasons may exist for an investor to extend the maturity date. For example, if qualified financing is predictably close, it may be in the investor’s best interests to extend.
Change of Control
A change of control implies an acquisition. For example, if an outside entity took control of the startup, this change could be because of its promise or because it is a distressed asset. In either event, the company must address the investors.
Companies have three options.
- Pay off the investors. Unfortunately, this payoff will likely alienate investors as they reap the smallest return for their early faith in the company.
- Pay off the investors with a 1-3% cash premium bonus to demonstrate appreciation.
- Transfer the note into preferred stock under terms similar to those in the note’s qualified financing provision and make the noteholders equity owners.
What Happens When a Convertible Note Is Not Converted at Maturity?
If the note fails to convert because the startup did not receive a first equity round, the note, including principal and interest accrued, becomes due.
Since conversion did not occur, the debt must be repaid.
What Happens to a Convertible Note If the Startup Fails?
The bigger question in startup law arises when the note fails and no conversion occurs.5
The only reason the note would not convert to preferred stock is that the company failed to attract an investor. A few options are available, including an extension, bridge financing,6 and repayment or foreclosure.
Extending the Maturity Date
The company and the investor could agree to extend the maturity date on the promissory note. Several logical reasons exist to pursue this course. First, the entire point of the promissory note was to allow the investor to obtain preferred stock later based on the valuation cap. Consequently, it serves the interests of both parties to allow more time for equity financing.
Second, despite failing to secure backing, the companies have leverage over most investors because the startup must agree to extend the note’s maturity date. However, leverage should not be necessary, as it is in the interests of all parties to find a solution.
If the investors foreclose, they may not recoup their money and will lose what they invested. Foreclosing could damage the investors’ reputations in the eyes of other startups,
Seeking Bridge Financing
Bridge financing may be the best option if the company needs more time and money. The company could renegotiate the original note or accept a new one. Either action is risky for the company because it will have to dangle new incentives and accept new terms.
Repaying the Convertible Note
The final option is repayment. The company must repay the note or risk foreclosure. Foreclosing is not ideal for either party. After selling off any remaining assets, the Internal Revenue Service limits the write-off to $1,500 a year for an individual and $3,000 if filing jointly.7
The information provided on this website does not, and is not intended to, constitute legal advice; instead, all information, content, and materials available on this site are for general informational purposes only. Securities law is complex and highly fact specific to any given circumstance and readers should contact an attorney for advice regarding any type of legal matter.
1University of Pennsylvania, Convertible Notes 101. https://sites.psu.edu/psleac/2020/09/27/convertible-notes-101/ 2University of Utah, Lassonde Entrepreneur Institute, What’s a Convertible Note? Read This Before Taking one. https://lassonde.utah.edu/whats-a-convertible-note-read-this-before-taking-one/ 3Securities and Exchange Commission, Convertible Note Agreement. https://www.sec.gov/Archives/edgar/data/1792013/000179201319000001/convertible_note.pdf 4University of Pennsylvania, Law School, Convertible Notes Overview https://www.law.upenn.edu/clinic/entrepreneurship/startupkit/convertible-note.pdf 5Carnegie Melon University, The Conundrum of Convertible Notes https://www.andrew.cmu.edu/user/fd0n/27%20Convertible%20Notes.htm 6Bridge Financing Explained: Definition, Overview, and Example (last updated October 28, 2020) https://www.investopedia.com/terms/b/bridgefinancing.asp 7Topic No. 409 Capital Gains and Losses, IRS https://www.irs.gov/taxtopics/tc409