Convertible Notes – Part 4

In this last installment of a four-part series, I look at the ownership position established when the promissory note component of a convertible note is replaced by an ownership certificate. ???

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.

?In its most basic form, an ownership position is granted by the purchase of shares, membership interests, partnership, or other recognition. Instead of an original funding, with a convertible note the investor provides cash to a small business in the form of the value of the previously made loan and any accrued and unpaid interest.

?The option to acquire ownership at a later date than the original investment provides a safeguard to the investor where the leadership sets an initial price on ownership that is so high that the investor is concerned that it will never be met.

The convertible note will state a price for a percentage of ownership in the business. By deferring taking ownership, the investor gets to take a ‘wait and see’ approach. If the apparent value of the business goes up to a level that meets or exceeds the conversion price during the term of the promissory note, then the investor can convert. If the value of the business does not climb to the level projected by the leadership of the business, then the investor may cash out and exit the investment when the promissory note is repaid.

?As an owner of the business, the investor participates in the future profits and losses of the business like any other ownership investment. The key difference is that the acquisition of ownership rights is deferred until the investor exercises the option within the convertible note.

?Because time passes while the investor holds the promissory note, conditions may change greatly affecting the future of the business and the merits of investing. Events such as COVID, inflation, or rising interest rates, all beyond the control of the business, may cause the investor's motivation to fall in becoming an owner and leave the business with a debt to pay.

?The term of the note will have a fixed date for payment. The business may go up in value, but not as much as the leadership of the business projected. This places the investor in a position of keeping the note looking for payment or going at risk by converting to an ownership position and hoping that the projected growth will occur at a later date but will still meet the investor's goals for a rate of return.

It is possible that the business may need to raise more funding before the due date of the note and before the investor has decided on whether or not to convert. The business must disclose to new investor candidates the existence of the convertible notes as existing debt and the impact on the ownership of the business if part or all of the notes are converted. The uncertainty of how the initial investors will decide to act may hinder a new offering.

?Some businesses will offer investors a discount from the purchase price of the next offering of equity as an incentive. This enables the investor to realize a gain on the conversion representing the dollar amount of the discount. If the investor immediately sells their ownership position upon conversion, then this gain becomes real money. If the investor waits to sell at a later time, there is still the risk that the value of the business may go down wiping out any gain and possibly resulting in a loss.

?Some businesses will build into a convertible note the option of buying out the note before the due date or it is converted. This option is exercised when the value of the business becomes greater than the projections.

?Whereas the note is for a fixed time, the ownership position may be indefinite. This change in the timeframe of the investment may be viewed differently at the date when the investor must choose. These changes may include a need for more capital, a change in leadership of the organization, and even a change in majority ownership such as a sale of the business. The convertible note should be drafted for each of these contingencies.

Like the promissory note component of a convertible note, the equity ownership position may be crafted with many variations to better fit the needs of the investor and the small business. Selecting these variations is best accomplished by developing a capital strategy that anticipates all capital needs of the small business over the next several years.

?Example: A small business seeks to raise $100,000. The business offers the investor a discount on the purchase price of its next equity offering if it occurs before the investor exercises its option to convert the note to an ownership position. Before the due date of the note, the business informs the investor of its intent to conduct a capital campaign. It sets a price for its ownership. The investor must decide to keep the note or take the discounted price.

?Exercise: Project the value of your business three years from now. Set a price for ownership based on this projection. Consider selling a convertible note that an investor may convert during the term of the note if this value is reached. Is it likely that an investor candidate will believe the value can be attained?

?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 the Grow Money Business podcast with Grant Bledsoe, where we talked about the challenges of raising capital for small businesses.

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

?I was a guest last Wednesday 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

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Karl Dakin, the Capital Coach

Dakin Capital LLC

[email protected]

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