What Is a Convertible Promissory Note?

Convertible notes are promissory notes that serve an additional business purpose other than merely representing debt. Convertible notes include all of the terms of a vanilla promissory note, such as an interest rate and the pledge of underlying security (if applicable). See Understanding Promissory Notes for Small Businesses and Promissory Note for discussions regarding standard promissory notes, together with related forms.

The difference is that the lender under a convertible note (called the creditor or the holder) has a right, under certain circumstances, to convert all or a portion of the outstanding debt under the note into stock of the corporation.

When Would I Use a Convertible Promissory Note?

It is commonplace for corporations to use convertible notes in business dealings. Here are a few likely scenarios:

• You've identified a lender that is willing to loan money to your company, and because the lender is confident in the company's future success, it wants to have the option of converting the outstanding debt into stock, exercising its rights as a stockholder, and participating in any future upside.
• Your company has an existing loan, and the business is growing, but it still lacks the liquidity to make repayments in accordance with the loan repayment schedule, if at all (in other words, the company is in payment default). In these cases, the lender could elect to negotiate with the company to replace the existing note with a convertible note to give the lender the option of becoming a stockholder with more direct input into the company's management.
• As the owner/majority stockholder, you need to personally loan more money to the business and want to have that debt reflected in an agreement between you and the company. In this case, a convertible note would be a better option than a regular promissory note because it would give you the opportunity to convert the debt into more stock, which would increase your ownership in the company. Note that before lending money to the company in the form of a convertible note or otherwise, you should always consult with your accountant or tax attorney.

Prepayment

As with a standard promissory note, a convertible note has to deal with the issue of prepayment. It is typically in the best interests of the company to have the option of making prepayments without penalty. However, as with any loan, prepayment would prevent the lender from receiving the future interest payments it had previously bargained for. Furthermore, in the context of a convertible note, sometimes a lender will resist prepayment because it sees promise in the company and would rather keep its options open to become a future stockholder. Prepayment is an issue that must be negotiated between the lender and the corporation, and it must always be clearly addressed in the terms of the convertible note.

Treatment of the Note

Until the lender converts the note into company stock, the outstanding balance of the loan is treated as debt, not equity, for accounting purposes. This means that until the note is converted, the lender usually does not enjoy any stockholder rights, including voting rights, rights to distributions, and so forth.

Triggers for Conversion

The terms of the convertible note can provide that the loan is converted into stock based on a variety of triggering events, which can include the following:

• Upon an event of default by the company (such as nonpayment of principal or interest, bankruptcy, liquidation, or a sale of the company).
• Automatically on the maturity date of the loan, assuming that the loan has not yet been paid in full. In such cases, the note would be converted to stock based on the outstanding balance of principal and interest under the loan.
• The lender's delivery of a conversion notice to the company at any time, for any reason.
• Upon the company's achievement of a specified dollar valuation stated the terms of the note.
• Upon the sale of the company to a third party resulting in a new majority shareholder.

If and when the holder is able to convert the note into equity of the company is a critical issue that must be carefully negotiated between the company (as borrower) and the holder. Given that stock ownership is generally the primary vehicle for a party to exert control over company management and earn a return on investment, the holder will want to have as much flexibility as possible regarding the conversion conditions. Similarly, the borrower will want to negotiate for as many delays and/or limits on conversion as possible.

Note that the risk for the creditor upon conversion lies in the fact that, in the event of a liquidation, debtholders get priority over equityholders in the distribution of remaining cash and assets. As such, if the holder converts its debt into stock, it will have relinquished its priority position if the company is dissolved or declares bankruptcy.

Methods of Conversion

Once the holder triggers a conversion, the next step is to figure out how many shares the debt is convertible into. Clearly, this is critical to not only the lender, but also the remaining shareholders, who want to be diluted as little as possible. All methods of conversion typically include accrued and unpaid interest in the calculation of outstanding debt. Also, the type of stock into which the note is convertible (whether it be common stock or a series of preferred stock) must be negotiated between the corporation and the lender. Furthermore, keep in mind that the calculations listed below might not always produce whole numbers of shares to be issued to the lender, resulting in fractional shares. The terms of the convertible note should specify whether or not fractional shares should be rounded up to the next whole share or treated some other way.

The following are various options for calculating the conversion of outstanding debt into shares of the corporation:

• The simplest approach is to state a predetermined price per share (which is usually discounted in favor of the lender) that will be used to calculate how many shares the holder should receive, based on the outstanding debt.
• The shares can be converted based on a set formula taking into account the company's valuation on either the date of the conversion notice, the date of the actual conversion, or some other date agreed-upon by the parties.
• In connection with a sale of the company, the shares can be converted based on a predetermined formula taking into account the price per share that is being offered by the buyer (calculated at a discount to the lender). Keep in mind that in this situation, the buyer will likely have reviewed the terms of the convertible note in connection with its due diligence investigation and will be aware of the company's obligation to issue additional shares to the lender in connection with its acquisition. This can be a potential turn-off to buyers. In any event, it is always a good faith practice to disclose the terms of the convertible note to the buyer as far in advance of the sale as possible. Otherwise, the buyer's unawareness of this issue could result in adverse consequences to the selling shareholders or the viability of the transaction as a whole.

Adjustments for Stock Splits or Recapitalization

Note that the terms of the convertible note, including those for conversion, should be subject to adjustment for any stock combinations, stock splits, or recapitalizations, unless any such modifications would be against the interests of the company (as the borrower) or you (as a potential lender).