A convertible note is a debt instrument that converts into equity under predefined conditions. Typical situations leading to conversion include:
A convertible note is interest-bearing and the interest will be converted into equity together with the principal amount at conversion.
A convertible note typically includes:
“Qualified financing” is the minimum size of fundraising to be achieved by the company which will trigger conversion. This represents a sufficiently large amount of funding that signifies the growth of the company to a stage that the investor is happy to become an equity holder instead of a creditor.
“Valuation cap”, also known as “price cap” or “conversion cap”, is the ceiling for the conversion price. This figure serves as the limit on the conversion price rather than a genuine valuation, which is often not possible at an early stage of a business with too little record and data available. Valuation cap price is arrived at by dividing the valuation cap by the number of outstanding shares at the relevant time.
“Discount rate” is the percentage discount to be applied in determining the conversion price. You should note that only the lower of the valuation cap price and the discounted price will apply.
“Maturity date”. The duration of a convertible note can vary widely – for example, 6 months for a bridge financing to a Series A financing to much longer timeframe (e.g., 5 years). The duration will have an impact on which type of investors can invest in the note – for example, some funds have a mandate not to invest in debt like instruments with a duration beyond 12 months. On the other hand, angel investors do not have such restrictions.
“Pro rata right” is the right for the investor to participate in the qualified financing (i.e. buying additional equity with additional cash upon the terms of the qualified financing), up to an amount that when taken together with the equity converted from the convertible notes, will result in the investor maintaining the same percentage of ownership in the company.
Pro rata right is often very important to more sophisticated seed investors because it gives them the right to follow on with their most successful investments and to potentially ‘protect’ their ownership stake during a potential down-round (round conducted at the lower valuation than the previous round). However, it could also mean reduced flexibility in negotiating with investors at subsequent rounds and can lead to renegotiation of these rights with earlier investors to facilitate the next round. This clause is offered as an option in the Convertible Note Instrument (if this right will be granted to all investors) or in the Convertible Note Subscription Letter (if you want to keep the flexibility to grant this right only to specific investors – for example depending on their level of investment).
“Dividend payments”. Investors in a convertible note are not shareholders and will not have right to potential dividends paid out before conversion. They will typically request that no dividend is paid out prior to conversion to make sure their investment goes to growing the company and not to paying existing shareholders. This clause is offered as an option in the Convertible Note Instrument you can create in the Dragon Law app, by which you can stipulate that the company will not pay any dividend until the convertible note is converted.
Step 1: Initial negotiation
You may create a Convertible Note Term Sheet to facilitate discussion with your investors. A term sheet is a simple and easy to read document, which is not legally binding.
Step 2: Creation of the convertible note
Create a Convertible Note Instrument on the Dragon Law app.
Creation of convertible note requires approval at both board and shareholders level. Instruct your company secretary to prepare the relevant minutes or written resolutions to record such approval, or contact our Client Service Team for assistance.
Execute the Convertible Note Instrument as a deed. Always check your Articles of Association for the requirement to validly execute a deed, or consult your company secretary.
Step 3: Subscription by investors
Create the Convertible Note Subscription Letter for each investor to evidence which amount of convertible note he will subscribe and how he will pay. Each investor will execute a separate letter.
This letter needs to be countersigned by the company to confirm acceptance.
Step 4: Completion of subscription
Upon the investor paying the principal amount to the company, the company will issue a Convertible Note Certificate to the investor. This certificate also needs to be executed as a deed.
Alternatively, if you have only one (or very few) investor(s), you may use a Convertible Note Subscription Agreement. This document combines a Convertible Note Instrument and Convertible Note Subscription Letter but requires a slightly different approval and signing procedure. If you wish to use this approach, please contact our Client Service Team.
There are numerous ways to construct a convertible note. You may agree with your investors that a different conversion pricing mechanism will apply, or in certain events the investor will get money back instead of equity. If you wish to create convertible notes of different mechanisms, contact our Client Services Team.
This document is a Convertible Note Term Sheet. When drafting this document, it is important to focus on the following key clauses: