Early stage companies often raise money from friends and family and angel investors in order to launch their businesses or bridge the gap to a larger raise. One method of raising funds is to issue convertible promissory notes to investors. A convertible promissory note converts to stock at a later date upon the occurrence of certain specified events; typically the closing of a larger capital raise where the company sells stock.
A triggering (or “qualifying”) financing is an equity financing that occurs subsequent to the issuance of a convertible promissory note, where a stated minimum amount of capital is raised. Upon a triggering financing, all principal and interest under the convertible promissory note converts to stock based upon the valuation of the company assigned at the time of the triggering financing. Typically, the conversion is “automatic,” meaning the investor does not have the ability to seek repayment of the loan at the time of the triggering financing, but must convert the note to stock.
The company should set the maturity date of a convertible promissory note conservatively to ensure it will have the time to build value, and close on the triggering financing prior to the repayment obligation on the note. Setting the maturity date too soon pressures the company to close on a triggering financing prior to building its value, which would result in selling stock at a lower valuation than anticipated or desired.
The typical interest rate for convertible promissory notes is between 7% and 10%. In the most common structure, all principal and interest is paid at maturity or converts along with the principal into stock.
All principal and accrued interest on a convertible promissory note usually converts into the same class of stock issued in the triggering financing, and on the same terms of such financing. That means convertible promissory note investors often receive preferred stock, with preferred terms, because these investors essentially tag along with the larger investor(s) in the triggering financing. Convertible note investors usually receive a discount to the valuation assigned to the company in the triggering financing, which results in a correlating discount to the price per share paid by investors in the triggering financing.
A typical conversion discount ranges between 10% and 25%, although it is possible in some situations to have conversion discounts of up to 50%.
A “conversion cap” provision provides that upon a triggering financing, the investor will convert at the option of the investor into stock at a valuation that is the lower of (a) the valuation after applying the conversion discount, or (b) a pre-set valuation. The conversion cap is a method of ensuring early-stage, convertible note investors are rewarded for their early-stage investment. If the triggering financing does not occur for quite some time, or until the company’s valuation has substantially increased, a discount to the triggering financing may not be attractive to convertible note investors.
John Cleary specializes in corporate and securities law, with an emphasis in representing companies seeking financing for their businesses through seed capital, venture capital, PIPE financings and public offerings. Mr. Cleary also regularly assists clients in mergers and acquisitions, advising both privately held and publicly traded companies in transactions involving the sale of assets, sale of stock, mergers, joint ventures, licensing, strategic alliances and other business combinations. His practice includes general corporate transactions and counseling, and he acts as outside general counsel for numerous local companies.He can be reached at john.cleary@procopio.com or 619.515.3221.
