Crowdfunding Lawyers

An Introduction to Convertible Notes: What Sponsors Should Know

March 9, 2023
An Introduction to Convertible Notes: What Sponsors Should Know

Getting an offering off the ground costs a great deal of money in many instances. That can be challenging for sponsors. You’re tasked with getting money into the opportunity, but you have nothing to sell.

Depending on the nature of the offering, you might be developing prototypes, working with architects, or collaborating with scientists. Of course, you haven’t started raising capital yet and likely don’t have a significant amount to invest on your own.

Convertible financing can offer a wide range of advantages. If you’re unsure of what convertible notes are, how this type of financing works, or whether it’s right for you, this introduction is the place to start.

 

What Is Convertible Financing?

Convertible financing goes by many names. You might be more familiar with “promissory notes” or “convertible notes”. Either way, it amounts to the same thing. In a nutshell, you’re agreeing to give the investor an ownership interest in the company down the road in exchange for funding now.

If used correctly, convertible notes can offer several important benefits, including simplifying the process of launching your offer, minimizing your costs, and creating a structure well-suited to working with private lenders and initial investors. Of course, they also help you move forward as quickly as possible.

 

The Debt vs. Equity Discussion

Let’s reflect a little bit on debt and equity.

Debt means you’re borrowing money. It doesn’t matter if it’s from a bank or a private lender. Note that a “private lender” can be an angel investor, but it can also be a friend or family member.

If you’re borrowing money but the lender is not taking ownership of the business, it counts as debt. This concept goes far beyond deal funding. For instance, if you owe money to a vendor, that’s a debt and it’s seen as a liability. While this concept differs from the idea behind convertible notes, it’s important to understand.

Equity, on the other hand, means ownership. It’s as simple as that. Equity can be structured in different ways where you have certain profit rights or voting rights that are different from other ownership structures. However, no matter what, we’re talking about somebody who comes in as a debt holder on your balance sheet and your capital stack. Still, they maintain a right they can convert that debt into an ownership stake later.

Your balance sheet tells you what you own and your liabilities at a set moment. If you subtract your assets from your liabilities, it equals your owner’s equity. Assets are things that you own outright. Liabilities are things that you owe to others.

You take your positive assets minus your liabilities, including debt. That equals how much equity your business or real estate opportunity has. That’s more of a financial analysis of how it affects your books and records, but it’s important to realize that convertible notes start as liabilities. Once they convert, it subtracts from your liability column and adds to your asset column, becoming equity.

Ultimately, the conversion affects your business’s books and its accounting process. This is important information to have particularly if you’re courting additional investors or finance partners. It’s even more important if you approach banks or other institutional lenders.

To sum up, convertible notes are promises of funding now in exchange for an equity stake in the business later. Any note holder has a right to convert their note into equity in the future. Most of the time, these are private lenders, not banks or institutions.

 

Banks, Debts, and Equity

One thing that surprises many sponsors is that banks have no great like for equity. They prefer debt. The reason for this is simple – it’s all based on repayment position. There is a priority interest in a company based on debt versus equity. When it comes to normal business operations, sponsors often find themselves s paying with credit cards. Those are debts.

If the cardholder doesn’t pay the bill, the card issuer can sue the company or foreclose on company assets. They are paid in full before any of the equity investors receive anything. For that reason alone, banks tend to avoid convertible notes and equity positions. It simply makes more financial sense for them to hold debt, instead of equity.

 

Convertible Note Documentation

It’s important to understand the documentation for promissory notes versus other financial instruments. For instance, there’s a loan agreement that discusses many of the same topics as a promissory note, which can be confusing, but there are some key differences sponsors can look for.

 

The Difference

Convertible notes are usually documents of a few pages. They discuss the highlights of when the loan matures and when payments are due, as well as what happens if the deal defaults, and other important details. They are very straightforward, even minimal.

The loan agreements may deal with similar concepts, such as disbursement schedules, requirements for reporting to the lender, annual tax returns, personal financial statements, and bank statements.

 

Bonds

Most people are familiar with bonds, but many are surprised to learn that they operate very similarly to convertible notes. The securities offerings larger corporations tend to use always have bondholder rights and are always secured to reduce risk in the event of liquidations or bankruptcy.

 

Debenture

Debentures are a third option and work similarly to both bonds and convertible notes. In this situation, companies raise funds by taking out unsecured loans from investors. However, that’s the primary difference. It also means that in the case of default, bonds take priority over debentures because bonds are secured, whereas debentures are not.

 

Convertible Notes: Using the Funds

The point of convertible notes is to access capital to use for business startup needs. Let’s explore a few important topics related to using those funds.

You’re starting a business and have a business plan, a dream, and a goal. However, you don’t have the money to pay for the organizational costs, meaning setting up a company, getting funding from a bank, and hiring prototype developers. If you’re going with real estate, you lack the capital for paying earnest money deposits or paying for the inspections of properties, which can cost thousands of dollars. In the case of construction development, you lack money to pay architects and engineers, deal with city and county regulations, and so much more.

Often, all that takes place before receiving financing from a traditional bank or seeking funds from private investors. This puts sponsors and business owners in a challenging situation. To get the business off the ground, they need funds. Convertible notes provide those funds and convert into equity in the future when a business might be seeking to limit its liabilities.

The capital raised from convertible notes is used for initial expenses, unlike raising capital from investors. In most cases, there is only one lender, as well. In most cases, this is a smaller amount best suited to help get the business across the starting line.

Creating an investment opportunity always costs money. For instance, graphic design, marketing collateral, and creating business entities all come with a price tag. No matter how great the idea behind the business might be, without money, it’s impossible to get started.

However, that does not mean that business owners cannot find funding based on their dream alone. This is where convertible notes enter the picture. The business owner simply needs to find a private lender who believes in their dream as much as they do and is willing to put a little money on the line to help transform that dream into a reality.

Convertible notes amount to a win-win for all involved if everything in the deal is on the up and up. The business owner gets the capital necessary to start moving forward. The investor can get in on the ground floor of what might be a lucrative business, plus has the right to convert their debt position to an equity (ownership) position. The debt position guarantees priority if the business fails, but the equity position allows investors to convert to a higher-earning opportunity should they wish to do so.

That priority position as a debtholder is perhaps the single biggest selling point for convertible notes. It’s the reason that banks rarely take an equity position and the reason that private lenders, whether they’re family, friends, or angel investors, will find it rewarding. They are first in line for disbursements if the business should fail. If it doesn’t work out, they can collect on the borrower.

If things work out well, they still have a prime situation. They can take an equity and ownership position in the business. In a way, this can be seen as a litmus test for the business idea. If a business owner can’t convince a single private lender to take a chance on their dream, there is little point in trying to do a full investment offering. That would require making the same sales pitch to 20 more people who are all likely to say no.

Finally, convertible notes allow business owners to learn to walk before they try to run. By starting with one lender, they’re able to hone their sales pitch to improve their chances of success when making a full offering.

 

In Conclusion

Convertible notes provide vital funding for business owners struggling to breathe life into their dreams. These smaller loans provide the capital necessary for the million things required before a business even launches, from logo design to creating a website, and so much more.

They’re also valuable for both the business owner and the private lender. Because convertible notes put the lender in a priority position in the case of liquidation or bankruptcy, they are first in line to receive funds in a worst-case scenario. That peace of mind goes very far in assuaging concerns about risk with an untried business. In a best-case scenario, the lender can convert the note to an ownership stake in the business once it’s off the ground and turning a profit.

Of course, getting started with convertible notes and building a successful business requires the right team, including an experienced securities attorney. Get in touch today to schedule your free consultation with Crowdfunding Lawyers and learn how we can help you transform your dream into a reality.

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