Use Convertible Promissory Notes to Grow Your Business
What is a Convertible Promissory Note?
A Convertible Promissory Note (“CPN”) is an option for companies that want to build capital without issuing stock or ownership units immediately. An investor, instead of receiving stock or another form of equity upon investment, would receive a CPN. The CPN is a form of debt that converts into equity (typically, preferred stock or units) when certain conditions are met. These conditions are decided on by the company and included in the CPN, which spells out a specific conversion procedure. By not issuing stock immediately, a newly formed company can delay valuation while still continuing to build capital through investments. The CPN essentially acts as a pre-paid investment in equity at a valuation to be determined later.
What are the key aspects of a CPN?
- Principal Amount: The amount of the investment, which is paid to the company immediately.
- Interest Rate: The interest rate accruing on the Principal Amount until the CPN either converts to equity or is paid back.
- Maturity: A CPN hits maturity at the date when the principal debt and the associated interest is due to be repaid to the investor, assuming it has not yet been converted into equity.
- Qualified Financing: The transaction (or series of transactions) that typically triggers when the CPN will convert to equity. For instance, a Qualified Financing might be the company’s sales of preferred stock in excess of a specific dollar threshold (ex. $1 million).
- Discount Rate: Upon conversion, the investor will receive equity at this discount. For instance, a 20% Conversion Discount means that a share of stock that is valued at $1.00 for purposes of the the Qualified Financing would instead be valued at $0.80 for purposes of determining the number of shares issued upon conversion of the CPN.
- Valuation Cap: This is the price ceiling that a CPN can be converted into equity; the dollar per share upon conversion will be at or below the valuation cap. A cap acts as a floor for the conversion because it indicates the lowest value of ownership an investor will receive. For example, a CFN with a Principal Amount of $1 million and a Valuation Cap of $10 million means that the CFN will convert to no less than 10% of the company equity, even if the valuation determined by the Qualified Financing exceeds the Valuation Cap.
Why do companies offer CPNs?
A company might choose to offer CPNs for a variety of reasons. They are most commonly used by new companies attempting to gain early capital and avoid a valuation that may be inaccurate. CPNs are a good idea if you don’t yet have the necessary data to accurately price your company. A company may also choose to use CPNs because they are typically cheaper to arrange than equity (because debt is easier and cheaper to structure than equity). CPNs can be offered before a company has developed and adopted detailed equity ownership documents. With CPNs, you can get the benefits of equity financing at the cost of debt financing.
Why should investors accept CPNs?
The money an investor puts into a company via CPNs increases the valuation of the company when it gets around to the Qualified Financing. If the valuation increases between the time the CPN is issued and the time of the Series A Preferred Stock financing valuation, for instance, an investor will be rewarded. Since CPNs are a form of debt, the investor can request cash as payment for the debt if the maturity date of the note occurs prior to the first round of Preferred Stock Financing.
How do CPNs work?
Like any other form of debt, a CPN will have to be paid back in full, plus interest. It will accrue interest until it converts into equity at the time of the Qualified Financing. The Qualified Financing that triggers the conversion into equity is important because it sets the share price that the CPN investors’ Conversion Discount will be applied to, in turn determining how many total shares the investor may receive as payment for the CPN.
In the following example, two seed investors have invested via CPNs $100,000 and $50,000 respectively into a company. Seed Investor 1’s CPN provides an annual interest rate of 8% and a conversion discount rate of 15%, and Seed Investor 2’s CPN provides an annual interest rate of 5% and a discount rate of 10%. They each purchased their CPNs on 1/1/2022, and the qualified financing of a Series A investment happens on 1/1/2023, at which point the valuation gave each share a price of $2.00.
|Convertible Note Inputs||Investor 1||Investor 2|
|Principal Amount of CPN (Amount Invested), (P)||$100,000||$50,000|
|Annual Interest Rate (r)||8%||5%|
|Discount From Series A Share Price (d)||15%||10%|
|Date of CPN Investment||1/1/2022||1/1/2022|
|Date of Conversion (Qualified Financing)||1/1/2023||1/1/2023|
|Calculations for Share Conversion||Investor 1||Investor 2|
|Interest Accrued (I)||$8,000||$2,500|
|Value of CPN at Conversion (P+I)||$108,000||$52,500|
|Series A Share Price (A)||$2.00||$2.00|
|Conversion Price reflecting Discount (Ad)||$1.70||$1.80|
|Shares Issued upon Conversion (P+I)/Ad||63,529||29,167|
|Shares Purchased with Equivalent Investment in Series A||50,000||25,000|
|Benefit to Investor of Conversion in Percentage of Additional Shares||27%||17%|
Because we’re attorneys: Disclaimer. Originally published June 5, 2022.