Convertible Notes – Part 3

In this third installment of a four-part series, I look at the promissory note that creates the debt financing part of the convertible note. ??

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 in the form of a promissory note for an ownership certificate.

?In its most basic form, a promissory note is a loan. The investor provides cash to a small business. It is expected that the small business will repay the loan with interest. The three key parts of the loan are the amount invested, referred to as the ‘principal’, the fee paid for the use of the money, referred to as the ‘interest’, and a fixed date when the loan must be repaid. Without all three keys, it may be impossible to enforce the debt in court.

?The promissory note serves as protection for the investor if the business fails. A debt holder stands in line ahead of equity owners in the distribution of proceeds or assets upon dissolution or bankruptcy. Having a priority position does not guarantee that the investment will be repaid because the business may not have sufficient assets. This is particularly true when the assets are sold at below market value through a foreclosure sale.

?To reduce the risk that the investor may be left empty-handed upon business failure, it is common for the investor to require the pledge of selected assets as collateral or security. This protection of the investor is similar to a bank lending money for the purchase of a car. It takes title to the car and is the technical owner until such time that the loan is paid in full.

?It is also common for an investor to require collateral of substantially higher value than the amount of the loan. In this manner, the investor is protected if the assets are sold below market value and to cover the cost of repossession and the foreclosure sale.

?The pledging of assets as collateral may create complexity in that it may be necessary for the same asset to cover several convertible notes. If all notes are not paid back in full and concurrently, then preferential payments will cause issues.

?The pledging of assets as collateral may also conflict with with debt financing of the small business. It is common for a bank and other financing institutions to make a ‘blanket’ request that all assets of the small business serve as collateral for a loan. Therefore, pledging assets as collateral for convertible notes may be prevented by a prior loan or may prevent a future loan.

?For greater reduction of risk, the investor may require that accrued interest be paid frequently placing a demand upon the money raised to be applied to interest payments and reducing the net cash available for use by the small business.

?If the investor does not exercise the option to convert to an ownership position, then the small business must repay the note by the due date.

?The possibility that the convertible notes need to be repaid and/or the pledging of assets strongly recommends that the small business develop a long-term capital strategy that encompasses all capital raises from all sources to maximize funds raised while reducing both the cost of money and the cost of administration of the loans.

?Example: A small business seeks to raise $100,000. The investor requires $200,000 of collateral. Interest must be paid monthly. If the investor exercises the option to acquire an ownership position in the small business, the money available will be limited to the original loan amount of the convertible note.

?Exercise: Consider the impact of your business taking on a $100,000 loan. Identify what assets you hold that may serve as collateral. Determine how pledging those assets may impact any other loans that the business may need.

?Upcoming Appearances

?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.

?https://thesupercrowd.com/17jan24

?Past Appearances

?I was a guest on Grow Money Business podcast with Grant Bledsoe where we talked about the challenges of small businesses raising capital.

?https://podcasts.apple.com/us/podcast/best-practices-for-raising-capital-with-karl-dakin/id1489821030?i=1000641138000

?I was a guest yesterday on Don Cohen’s Hour of Empower where we talked about the importance of projections in small business success.

?https://www.dhirubhai.net/video/live/urn:li:ugcPost:7150879258117070848/?msgControlName=view_message_button&msgConversationId=2-ODM2NDkwMzktNjQxMi00MDQ3LWFlZDAtZTUwZGRhMDhlNDkxXzAxMA%3D%3D&msgOverlay=true

?Subscribe

?If you benefited from this newsletter, please Subscribe and share it with others.

?

Karl Dakin, the Capital Coach

Dakin Capital LLC

[email protected]

?