Convertible Notes – Part 2
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.
In this second installment of a four-part series, I look at the actual conversion from debt to equity ownership. ?
In simple terms, a convertible note is a promissory note that may be converted into the purchase of equity ownership in a business at the option of the investor.
?If exercised, the investor swaps out a debt instrument or an ownership certificate.
?In its most basic form, the price of the new ownership is equal to the original principal of the promissory note and all interest from the date of the note.? Within the terms of the convertible note, a price has been set for the ownership interest. A simple calculation determines how much ownership may be purchased.
?It has been my experience that rarely does anyone use a basic convertible note. Several common variations may cause the convertible note to look more like a simple agreement for future equity (SAFE).
?Businesses may offer the investor an ownership position at a floating price point. The price is dependent upon a future equity offering. When the business sets a price for ownership in the offering to the general public, that price is used for the conversion. The convertible note may be activated at this price point. In this manner, the convertible note is like a warrant or stock option. However, a partial price has already been paid through the investment in the note.
?It is also common to include a discount when a floating price is used for the conversion baseline. The investor may obtain the ownership position at less than the list price of the public offering. The discount may vary but often falls between 5% to 20%. Other, additional incentives may be granted to the investor.
?The more the investor is concerned about the potential failure of the business, the more likely that the business will be required to make regular interest payments on the promissory note. In this case, no interest accrues, and the conversion is limited to the original amount of the principal. The interest rate must be taken into consideration when pricing the ownership interest as the combination generates the investor's total rate of return.
??A conflict may occur between the term of the promissory note and the time for the business to grow in value. If the business projects that it will achieve its increase in value in three years, the term of the note should mirror that time frame. Otherwise, the investor is still being asked to pay a high price for ownership before the business has fully proven itself.
?Like any investment, the use of a convertible note requires guessing the future. The terms of the convertible note should, like an offering memorandum, provide for as much change in the situation as possible. This may include all the ordinary risks of a small business such as changes in markets, products/services, and management as well as extraordinary events (which if they keep occurring at this rate become ordinary) such as inflation, interest rate changes (both up and down), international wars and rapidly advancing technology.
?Example: A small business grants an investor a convertible promissory note paying interest at 20% for an investment of ?$100,000. Upon exercise of the conversion option, the investor will receive an ownership position in the business. The purchase price of the ownership is tied to the next private equity funding round which exceeds $1 million in capital. The investor is granted a price at 10% below the price set in the offering. If the option is triggered at the end of Year 5, the investor has their original $100,000 in investment, $100,000+ in compounded interest, and the value of the discount before potentially realizing an appreciation in the ownership position in future years.
?Exercise: Look into the future and pick a date for your next equity funding round. Determine what interest rate you would pay on money received today until the next funding round. Then consider what discount you may offer an investor candidate as an extra incentive to make the loan today.
?Upcoming Appearances
?I will be a guest today on Don Cohen’s Hour of Empower at 9 am MST where discussions will again center on entrepreneurship and the topic of projections.
?I will join a group of speakers at SuperCrowd Hour next week on January 17, 2024, at 1 pm EST where we share information on crowdfunding, impact investing, and the potential of equity crowdfunding to reach $300 billion.
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Karl Dakin, the Capital Coach
Dakin Capital LLC
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Like most funding offerings, convertible notes may be drafted with a wide variety of terms and conditions that may benefit and incentivize the investor while also protecting the small business.