Convertible Notes – Part 1
Karl Dakin
I help you overcome challenges to raising capital. Take advantage of my Motivated Money Method to identify those investor candidates that are most likely to invest. Top expert in fundraising.
A common offering for funding is called a convertible note. I will present information on this type of investing in four parts:
·?????? Part 1 – Analysis
·?????? Part 2 – Promissory Note
·?????? Part 3 – Equity Purchase
·?????? Part 4 – Conversion
In simple terms, a convertible note is a promissory note that may be converted into the purchase of equity ownership in a business.
?It is commonly offered by a business to an investor candidate to overcome two objections to investing:
1.???? The risk of failure by the small business is too high
2.???? The price set by the small business for equity ownership is too high
?The first objection is addressed by the investor becoming a debt holder instead of holding an ownership position. If the business fails, if the business owns any assets they will be sold. Proceeds from the sale are distributed based upon a priority set by bankruptcy law. This means that debt holders are paid in full first before any distributions to any owners. By an investor starting as a debt holder, they are in a superior position to an ownership position if the business fails. There are many more issues to consider as a holder of a promissory note, in particular holding collateral or some other form of security, that I will discuss in Part 2 on Convertible Notes.
?The second objection is addressed by giving the investor an option to convert the promissory note into a payment for equity ownership at a later date. If the business increases in value to a level equal to or greater than the leadership of the business projected, then the investor exercises their option and becomes an owner. If the business does not increase in value to a level high enough to satisfy the investor, then the investor keeps the promissory note and looks to the business for repayment of the principal and payment of accrued interest. As with promissory notes, there are many more issues to consider as an owner that I will discuss in Part 3.
?On its face, the ability to overcome these two objections and obtain an investment appears to provide an elegant solution for a small business to raise funding. However, there are serious issues to consider from the standpoint of the investor, the small business, and securing the investment. These issues may impact how the wording of the conversion of the promissory note to an ownership position occurs which I will discuss in Part 4.
?The convertible note is often viewed as a safety net for the investor. If the business fails, the investor holds a promissory note and falls into the debt-holder class in bankruptcy. Although the investor stands in line ahead of the business owners, this means nothing if the failure of the business leaves it without any assets. There is nothing to sell. There are no proceeds. The investor takes a loss of their investment – both principal and any accrued and unpaid interest.
?The business assumes that it will succeed and prove its valuation and that the note will be converted to ownership. However, until the conversion occurs, the business must carry the promissory note on its books as a debt that shows up on its financial statements. The existence of the debt may hinder the business from obtaining other debt financings for equipment, a mortgage or an operating loan. In addition, the investor may not convert the note into an ownership position leaving the business in need of cash to pay off the note. If the investor does not convert, it is common that the business is not performing well and may lack the cash to make the note payment.
?Finally, in seeking an investor, the business may find that investor candidates who are willing to invest through a convertible note are too few in number. Why would an investor candidate invest in a business with the risk that it may fail? The investor candidate must either believe that the risk of failure is low or that the potential future value of the business is high. Although these outcomes are not mutually exclusive, they generally are not found together. If the investor believes in the business, it may be expected to take an equity position without the action to safeguard the investment with a promissory note. If the investor does not believe in the future success of the business enough to take an ownership position, why invest at all?
?Example: A small business seeks to raise $100,000. It projects the future valuation of the business at $5 million in five years and offers investors an equity position of 10%. If the projected valuation is achieved, the $100,000 investment will become worth $500,000. An investor candidate questions the projected valuation but agrees to take a convertible note for the $100,000 investment paying an annual interest rate of 20% with an option to convert to a 10% ownership position anytime over the next five years.
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?Exercise: Consider the impact of your business taking on a $100,000 loan. How will it look on your books and records? How will it affect any debt financing you already have? How will it affect any additional debt financing you may need or want within the next five years?
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Karl Dakin, the Capital Coach
Dakin Capital LLC
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I help you overcome challenges to raising capital. Take advantage of my Motivated Money Method to identify those investor candidates that are most likely to invest. Top expert in fundraising.
10 个月I am not a big fan of convertible notes. I have found that too many issues are overlooked or dismissed in this popular funding tool.