Convertible notes offer a simple, streamlined means of starting a business before making an offering. Business startup costs can be considerable and include everything from business registration fees to graphic design and web hosting. Without an offer to market to investors, the business has no cash flow. Convertible notes provide the necessary capital to jumpstart the business until investment capital begins flowing.
However, using convertible notes correctly can be challenging for those new to this situation. In this post, we’ll explore what business owners should know about convertible notes, how they work with securities, and what you can use the funding to achieve.
What Is a Security?
Before diving too deep, let’s back up just a bit. Convertible notes can play a role in securities, but what is a security? It’s a type of investment, but all investments aren’t securities.
The difference is important because the consequences of falling under a securities rule or breaking one can be immense. They can include being required to pay massive fines, being kicked out of the investment industry entirely, or even jail time. Chances are good that most people recognize the name “Ponzi” – a type of securities scam that landed Bernie Madoff in prison for life.
Unsure if your offering is a security or not? There’s a test for that.
The Howey Test
The Howey Test is designed to test for securities regulations. A security is technically nothing more than pooling together the funding from multiple investors for them to make a profit off your efforts or the efforts of others. If you’re doing this with more than one investor, your offering is a security, and all securities regulations apply.
How does this tie in with convertible notes? Because these notes operate in exactly the way we just described, it’s tempting to think that they fall under securities regulations, but because you’re only working with one investor in this way, you are free and clear. So long as you’re not pooling the funds from multiple investors, your offering is not a security.
When working with a single investor, there must be a pool. That investor is seeking a profit and that comes from your efforts. The investor isn’t doing any work – they provide you with the capital and then sit back and earn a return.
The point is this: if you’re using convertible notes and working with a single investor, you don’t need to worry about securities regulations. If you’re working with multiple investors, then you need to pay attention to those regulations because chances are they apply to you.
What Can You Use Funding For?
You can take two paths when it comes to funding with convertible notes. First, you can have your LLC set up already, in which case the LLC becomes the borrower. The promissory note(s) can be in the company’s name, and everything is tied to the LLC itself.
The second path is for those who’ve done less business building initially. If you don’t currently have an LLC, you can become the borrower yourself. In this instance, you borrow the money for a specific purpose – to set up your new LLC. You can even name the business in the agreement. You must also specify that the debt will convert from you, personally, to the LLC. Otherwise, the lender can sue you personally if things don’t turn out well.
The idea that underpins convertible notes is simple: you’re using the funding to pay for the costs incurred on the front end of building a business. You can use those funds in many ways, including:
- Earnest Money Deposits: Earnest money deposits, meaning a deposit saying we want a right to buy the business or real estate later. There are generally inspections that take place.
- Suitability: Does the real estate make sense for your own goals? You often hire third-party inspectors or accountants to dig through the accounting to make sure that it’s a wise purchase. All these expenses are contingent because they’re yours, and the bank isn’t paying for them. An investment offering is paying for it once you get to the closing table and buy it. The convertible notes allow you to borrow the funds to cover all those expenses.
- Legal Expenses: There’s always a cost in any merger/acquisition transaction or setting up your LLC properly working with your partners, creating the service contracts, or purchase agreements. For those raising funding from private investors, often there are securities offering expenses, putting together the 100-200-page documents, to legally offer securities to raise capital from the masses.
- Marketing Expenses: Because you’re doing business plans, email campaigns, and paying to go to conferences, there are often marketing expenses that must come from your pocket upfront. Hopefully, they’re reimbursed once you get to the closing table and acquire the asset.
A Real-Life Example
Let’s say you’re planning a business acquisition. You borrowed $100,000 from a convertible note lender to pay for all the legal requirements and marketing, find investors to pay for it, and conduct suitability testing and investigations to ensure you have a good opportunity.
You spend the money. The investor has a $100,000 note and you close on the property or the asset. Now, from the closing table, there are a couple of different avenues. First, the money can go to pay off the lender with interest. That’s a great opportunity for profit on a concise term transaction. Second, they can convert some percentage of that note to an ownership stake in your company.
When it comes to conversions, it’s often done at a 10% or 20% discount to what other investors come in at due to the risk the lender takes on by investing in an asset before it even exists.
Let’s touch on contingent offerings briefly. In this situation, you’re buying a business or real estate and waiting for something to happen. If it does not happen, the deal does not move forward. It’s contingent on that occurring.
In contingent offers, fund usage is strictly regulated. For instance, you might tell investors that you need $100,000 to open your new Subway franchise. You can only tap into their funds once you reach that amount, allowing you to open the franchise. You cannot use any funds before that. Trying to use those funds beforehand leads to financial shortfalls for your investors, and that’s where most investment lawsuits begin.
Convertible notes are often made for the specific purpose of paying for high-risk expenses before you get to the closing table. Once you acquire that asset and move forward with the business, the risk reduces quite a bit. This is one reason it is generally separated by raising capital from multiple investors for the closing.
As an important note, whether it’s the convertible note or dealing with permanent investors, ensure that your business is safe. Protect your partners and yourself. This requires disclosing exactly what you believe is going to take place, but also the risks relating to the transaction.
For example, with a promissory note, there’s a risk that the asset doesn’t close, the funds aren’t raised, or it doesn’t make sense to move forward. The risk is the lender now relies on either the LLC or you to pay them back. That’s a different risk than investing in a contingent offering.
You have many options when it comes to converting notes. We’ll discuss some of the most important ones below.
- Discount: One strategy may be offering a discount on investing or a securities offering to the private lender compared to what other investors receive.
- Future Valuation or a Sale Trigger: Either the investor must agree to convert at certain terms, or there can be an automatic conversion if the company gets a valuation of a certain level or an offer to buy or sell the company from a third party. These are often used as trigger mechanisms.
- Issue a Promissory Note: Issue a promissory note that goes right along with an option when an option or a warrant means it offers a designated price and a period during which you’re allowed to buy stock, or you’re allowed to buy an interest in the company at that designated price.
- Stock Options or Warrants: A stock option is a contract that allows you to buy a share of stock at a designated purchase price. Often, there’s no share value other than what management says it’s worth, or the value offered to investors. Options and warrants are the same and most often used with public companies, rather than smaller investment opportunities.
The Conversion Process
The conversion process from note to ownership stake is more complicated than many people assume.
It all begins with a note from the lender stating they are ready to convert their ownership of the notes into ownership within the company. For those using a transfer ledger, this note just means that the ledger is being updated and that you have one less lender and one more owner. They’re now an equity holder.
Finally, the business will need to sign and send a document back to the ender that recognizes the transfer has been completed. In some cases, this can be a stock certificate, but they are rarely used today unless someone specifically requests one. In most cases, it will be a one-page assignment that reflects the cancelation of the loan, a payment assignment, and a transfer of ownership interest directly to the specified lender.
In terms of the loan, all loans have a maturity date. It may be 25 or 30 years down the road, but there is always a maturity date. However, when it comes to these types of transactions, the period is less than 10 years. Most often, it’s a three-to-five-year period. Some are even shorter, following a three-to-six-month period.
Why are there three to five years agreements versus three to six months agreements? It depends on specifics within the transaction or deal. If you’re going to buy a real estate asset, you should close in three to six months. If you’re starting up a business and need to reach profitability, it may be more of a three-to-five-year term. However, no matter what, you’re borrowing money for a fixed period. Then the conversion generally also has a period when you can convert during a certain time, or you must convert at a certain trigger.
If there is no conversion, then the payoff naturally must happen at maturity. It looks just like a regular loan. If the lender does not convert as defined underneath the investment contract note, they’re just operating like a regular lender and get their money back with whatever interest accrued.
When used correctly, convertible notes provide the capital needed to get a business off the ground or to take the first steps toward realizing your real estate purchase. However, you must move forward the right way to avoid violating securities regulations. It’s also important to understand how these notes convert and the options available to you as the business owner, and the lender offering the note.
There is no “easy path” to success when it comes to these kinds of offerings. You must have experienced legal guidance at every step. Contact us today for a free consultation and to learn more about how Crowdfunding Lawyers can help ensure the success of your deal.