Convertible notes provide a way to get your business off the ground before conventional funding is available. They answer the challenge created by being unable to market to investors and the need to pay for things like logo design, website creation, and the development of marketing collateral to reach those investors in the first place.
However, there’s a world of difference between knowing what convertible notes are and using them to launch your organization or jumpstart your offering. It’s essential to understand how to get started, how to locate your first lender, and then how to structure your note. In this post, we’ll explore what you should know.
Before Doing Anything Else
Before you start looking for your first lender, you must verify your opportunity is not a security. It’s all about minimizing risks to yourself, as well as to any lender(s) and eventually to your investors.
Remember that you will be taking a substantial percentage of someone’s net worth. Because of that, they have certain additional rights when it comes to collecting, especially if any fraudulent practices were used. For instance, the state attorney general often has a right to act on behalf of private lenders. If they believe that you’re gaming the system or cheating your investors in any way, they will act against you.
It’s also important to remember that if things do not work in the lender’s favor during your deal, they will usually complain to the regulatory authorities. Private lenders do not take the loss of capital lightly. They will attempt to recoup their money.
Finding Your First Lender
When it comes to private lenders, it’s important to work with just one initially. Having just one private lender reduces your risks compared to a securities offering. However, an investor must remain below 20% of their net worth in terms of what they’ve put into your company. Some states, such as Arizona, only allow up to a certain percentage of net worth investment in these cases, and 20% is something of an industry best practice.
It’s also important that you work with accredited investors. Again, this is about reducing risk exposure. There are very limited disclosure requirements and other information to share with accredited investors. What’s an “accredited” investor, though?
This is a securities concept, but it applies within a risk analysis situation. If an investor has a net worth of more than $1 million or they earn more than $200,000 per year ($300,000 with a spouse) for the foreseeable future, they count as an accredited investor. That is, the loss of their investment will not cripple them financially.
Understanding the Structure of Convertible Notes
While every convertible note will be different, they all have similarities. In this section, we’ll explore the general structure that these notes take and help you understand how they’re constructed.
Most convertible notes start with an introduction. This is relatively self-explanatory. This is where the general onus of the loan is explained, as well as what documentation is needed and what investors should know. The introduction is included with the note but isn’t technically part of it. You can think of it as a forewarning for investors that they should review this information before signing an agreement. It spells out the various requirements for a purchase to be accepted.
The heart of the note is the loan agreement itself. However, it’s helpful to think of these more like investment contracts than loan agreements. In this instance, the investor is purchasing a promissory note directly from the deal sponsor or company.
They will own this as an asset, which is why it’s viewed as a purchase agreement and not an investment agreement. However, like a loan agreement, all the terms and conditions about investor suitability, as well as timing for conversions and repayments all come together through this convertible note purchase agreement.
The fluidity of terms and structures here can confuse people. The simplest way to keep things straight is to realize that this is the trigger that allows an investor to say, “I agree to these terms, now sell me your debt instrument.”
The agreement spells out requirements and standards for investors, but also what’s required of the company and what rights the company must enforce conversions, as well as when they must pay back the money borrowed.
The Promissory Note
The promissory note incorporates the terms and conditions of the investment agreement that apply to both the company/borrower and the lender. It reflects a debt holding by the lender and debt obligation from the borrower, in the most simplistic of terms. However, if there’s ever a lawsuit, or if the lender ever needs to go to court to enforce their rights, it will come down to this simple promissory note document signed on behalf of the borrower.
It lays out the loan terms, the maturity date, the interest rate, whether the opportunity is a security or not a security, and how the mechanics operate in a very shortened form.
The conversion election is designed to make the lender’s life easier. It essentially spells out how the conversion election must look. In many cases, it might be little more than a paragraph that states, “I am electing to go ahead and convert my debt into equity.” It’s designed to provide a simple, straightforward path to equity conversion and to ease any worries the lender might have about the conversion process. When they realize it’s as simple as submitting a statement that they are converting their debt into equity, most lenders enjoy considerable peace of mind.
The final part of the convertible note deals with lender suitability. It is also the most important portion of the document. This is where borrowers/companies must gather information from the lender about where to make payments, their background, and more. It’s often called KYC – know your client.
This section is where the borrower details who the lender is, whether they’re accredited and if they’re not accredited, to show proof of sophistication (meaning that they understand how these investments work and the level of risk to the capital involved).
Essentially, this section exists as a catch-all to highlight all information about the lender, from their level of education and sophistication to the amount of interest the borrower has paid. The more detailed, the better, as this can help you avoid the notice of regulators.
Convertible notes offer access to immediate funding that would not otherwise be available to aspiring business owners or deal sponsors. They help ensure that you’re able to pay for all those necessities before a business can turn a profit.
Additionally, they can be relatively straightforward. Use the information in this post to help ensure your agreements are structured correctly and contain the details necessary to protect your business and the lender’s interests. Interested in moving forward with a deal?
Get in touch today to schedule a free consultation with Crowdfunding Lawyers and learn more about how convertible notes can jumpstart your business.