If you are in a seed round or another early-stage funding round, you may want to consider investment in the form of convertible notes, also known as convertible debt or convertible bonds. Convertible debt can be favorable for both founders and investors because convertible notes help ensure that the valuation of your startup is in line with the economic reality and growth potential of your startup. If you are looking to negotiate the use of convertible debt in your venture capital rounds, consult a startup attorney from the Priori network to learn about your options as a founder—and how to make convertible debt work to your advantage.
About Convertible Notes For Startups
A convertible note is short-term convertible debt that converts into equity on a specific date or when a specific event triggers its maturity. A startup will issue a convertible promissory note in convertible debt transactions. When a startup reaches the date when debt converts into shares or when convertible notes mature, such as closing a Series A round of financing, the convertible debt automatically converts into shares of preferred stock. Through this method, your startup receives capital right away, but the amount of shares conferred to investors is established at a later date when there is more information to guide the valuation. Converting convertible notes into stock generally occurs automatically in a predetermined manner once triggered by a specified event as stated in the agreement.
Advantages of Convertible Notes For Startups
There are many advantages to raising funding through convertible debt, especially in the early stages of your startup. The following are the four most important reasons why this method of fundraising may be beneficial:
- Valuation issues are delayed. Setting a fair valuation for a startup is almost impossible at the early stages, which can make negotiating with potential investors incredibly challenging. Convertible notes allow startups to delay valuation issues to a later time when such decisions can be based on established data.
- Speed and simplicity. Convertible notes make negotiations with investors simpler, which may speed up the fundraising process.
- Convertible notes rarely confer immediate control to investors. In most cases involving convertible debt, you maintain control of your company--and executive decision-making rights--until the convertible notes convert into equity.
- Flexibility. Since convertible note caps (the maximum valuation that investor shares are based on) are not actual valuations, you have more flexibility to change this number depending on the investor. This gives early-stage funding more flexibility.
Convertible Notes vs. Equity
Convertible note financing is similar to equity financing, in that both fundraising methods allow startups to receive capital. However, they do so using different methods. Convertible notes transfer equity to investors at a later date, whereas in traditional equity-based investment deals, this transfer happens immediately. Technically, convertible notes, also known as convertible debt, are a loan that is paid back through equity, while an equity-based deal is a direct trade.
Because convertible notes are technically a loan, taxation of investors and the company is delayed until the notes convert. This can make the taxation issues related to convertible debt complex.
Convertible Debt Taxes
Because a convertible note has both debt and equity features, convertible debt is taxed differently in each situation, depending on your rights and benefits as an investor as stated in the underlying agreement. Generally, however, a convertible note carries no tax responsibilities until after its conversion. At this point, there are capital gains that are taxed the same way as other gains in the same category. The conversion itself is generally not considered a gain under the federal tax code, but again, this will depend on the exact nature of your agreement. Consult a tax attorney to find out exactly what your tax responsibilities related to convertible notes may be.
Convertible Notes FIRPTA Implications
When considering the tax issues related to convertible debt, FIRPTA implications are important if you are a foreign investor. Under the Foreign Investment in Real Property Tax Act (FIRPTA), it is not clear whether or not convertible notes are considered “Type (A)(i) property,” defined as “any interest, other than an interest solely as a creditor, in a domestic corporation.” As convertible debt makes investors creditors, FIRPTA is unlikely to apply, but upon conversion, you should consult with your CPA or an experienced tax attorney to determine if your investment falls under FIRPTA jurisdiction.
What Happens After Default?
Unfortunately, not all startups are ultimately successful. So what happens to those unlucky companies that cannot raise another round of financing or end up in default? Technically, investors have the right to demand repayment right away. In reality, this rarely happens, as the company usually has little money and assets at this stage, and such a demand could push the startup into bankruptcy —almost ensuring that the investor ends up with immediate losses.
More commonly, investors choose to give the startup more time to succeed. This can be accomplished either by changing the maturity date entirely or simply converting the convertible notes into preferred or common stock. The investor then hopes that the company will succeed and the investment will pay off—or at the very least, break even.
Depending on your needs, the cost of convertible note financing can vary based on a number of factors. Priori lawyers offer transparent flat fee packages for convertible note financing ranging from $450 to $7,500. In order to get a better sense of cost for your particular situation, you can put in a lawyer request, schedule a complimentary consultation, and receive free price quotes from our lawyers.
Can you issue convertible notes for LLCs?
Yes, you can issue convertible notes for LLCs, but this approach is rare. Transferring equity to the issuer of a convertible note once the convertible note matures is more complex in such cases, and the process must be laid out in the LLC's operating agreement. Also, LLCs may have difficulty attracting investors using convertible note financing; in general, investors prefer to invest in corporations. If you want to pursue this option, you should talk to a startup lawyer about incorporating the necessary language into your LLC’s operating agreement.
What happens if the maturity date occurs prior to the note’s conversion to equity?
Like most loans, convertible notes have a fixed maturity date by which repayment of the total amount borrowed, plus interest, is due. When a convertible note reaches maturity prior to its conversion into equity, this becomes a very precarious situation. Technically, the loan cannot be fulfilled without a valuation. Usually, parties address this issue by negotiating a loan extension with terms less favorable to founders. Occasionally, investors will instead agree to immediate conversion into equity at a set valuation.