An Introduction to the Types Convertible Notes
This post is the first in a series of posts exploring the mechanics of convertible promissory notes. Convertible promissory notes are usually referred to simply as "convertible notes".
Convertible notes are frequently used by startup companies for two purposes.
- Most commonly, convertible notes are used to finance early growth activities before the formation of larger amounts of 'priced' equity capital. Convertible notes are ideal for this purpose because (1) they can be issued at a low transactional cost, and (2) they can be issued on a rolling basis.
- The second common use of convertible notes is to secure bridge financing. This normally is done to allow the company (referred to as an "issuer") to achieve certain performance metrics in advance of a round of additional priced equity capital. This is especially common when an issuer is going to have a cash short-fall prior to their next equity raise.
Types of Convertible Notes
In general, convertible notes come in two varieties. The first type of convertible note is sometimes referred to as a "stand-alone" convertible note. In this type of convertible note, all the salient terms of the instrument are captured in a single document.
In a stand-alone convertible note, the note is the transaction document and the evidence of debt simultaneously. The issuer negotiates each convertible note with the person holding the instrument (usually referred to as the "holder," or "noteholder,").
This offers the issuer a great deal of flexibility in negotiating terms with each noteholder. For purposes of defining a discrete round of fundraising, stand-alone notes can still be issued as being part of a series which denotes similar terms or timing of the convertible notes.
Credit Facility Approach
The second convertible note variety can be described as a class (or series) of convertible notes. In this model, discrete convertible notes are issued pursuant to a common note purchase agreement agreed to by all noteholders. This is sometimes referred to as the credit facility approach.
This variety is commonly used in the event that a single party negotiates the salient terms of the convertible note. In this approach, all of the terms of the class of convertible notes in the same issuance are established in the note purchase agreement.
Each noteholder executes a the common note purchase agreement and the issuer issues each noteholder a convertible note. The convertible note serves as evidence of the principal amount owed and references the note purchase agreement for the purpose of establishing most other terms associated with the convertible note.
Which Approach is Better?
By and large, the reason for selecting one method or the other of issuing convertible notes is a dealer's choice.
For example, an issuer may find it easier to negotiate the terms of a large convertible note round with a principal investor. Thereafter, smaller investors follow the terms set by the lead noteholder. In certain instances, the issuer may be able to negotiate to treat the the noteholders of a round of convertible note financing as a common class. For example, instead of negotiating with each noteholder, the issuer may need only the approval of a majority of noteholders -- treated as a common class -- to approve an amendment to the note purchase agreement.
On the other hand, when an issuer is contemplating taking investment from differently situated investors, the issuer is likely to find the use of stand-alone promissory notes to be preferable. Because each investor has unique strategic goals, the issuer can negotiate tailored terms accordingly.
In our next post in this series, will discuss the most commonly negotiated terms of convertible notes.