Introduction

Convertible Financing: Gives private lenders a right to take ownership interest in your company down the road.

• Lenders are debt holders on your balance sheet.
• Lenders maintain the right to convert into ownership at a later time.

Debt v. Equity

Debt is borrowing money you’re not taking ownership of.

• Ex: Accounts Payable
• Priority interest in a company based on debt

Equity means ownership.

Balance Sheet is a representation of equity and debt.

Assets are things that you own (equity).

Liabilities are things that you owe to others (debt).

Owners Equity = Assets – Liabilities

• How much equity your business/real estate opportunity has.

Convertible Debt Lenders start in the liabilities category and convert to equity after they convert to ownership.

[The conversion of convertible notes affects your business’ accounting & records!]

Convertible Note Documentation Compared to Other Debt Types

Promissory Notes: Usually a few-page document that highlights when the loans mature, when payments are being made, and what happens if things default.

Loan Agreements: Similar concept of promissory note documentation but includes other concepts – disbursement schedule, requirement to provide lender with reports, and other additional requirements.

Bonds: A Bond is the same thing as a Promissory Note, just called something different.

• Bonds are often used by larger corporations for offerings.
• Bonds have secured bondholder rights in case of any liquidations or bankruptcy.

Debenture: A Debenture is almost the same thing as a Promissory Note, but differs in priority.

Accounts Payable: Is another form of debt. It may be based on a purchase agreement or other invoices with repayment terms. (Ex: credit card)
 

How Do I Use The Funds?

Why use a convertible note?

If you’re starting a business, have a plan and a goal, but you just don’t have money to pay for the upfront organizational costs. Convertible Notes are used for initial expenses and funds are generally raised from one lender.

Where do I find my investor?

With a Convertible Note, you can go out and find that one lender that believes in your dream – it can be your mom, grandma, or friend down the street – anyone who’s willing to contribute to helping you get started with your business.

What happens for my lenders when my business plan works out?

If things work out wonderfully, no problem – your lenders get to take an equity and ownership position in your business.

What happens if it doesn’t work out?

A major selling point for using Convertible Notes is the fact that lenders come in at a priority position. Meaning that if a business plan doesn’t work out, lenders have a right to ownership of any assets that apply to the business and can collect on the borrower.

What is a security?

All investments are NOT securities!

This concept is extremely important to understand, as the consequences of neglecting or breaking a securities rule can be massive. Including, but not limited to, going to jail, being kicked out of the investment industry, or paying massive fines.

The Howey Test: A test for securities regulation.

• Pooling together multiple investors funding for them to make profits on your efforts or the efforts of others.
• If this is done with more than 1 investor, it is a security, and all securities regulations apply.
• As long as you only have 1 private lender, you do not need to worry about the convertible notes under securities regulations.

How/Where do I hold the funds?

Strategy 1 - Already have LLC set up and that LLC is now the borrower – the Promissory Notes can be taken out in the company’s name, and everything will be based on that LLC itself.

Strategy 2 – You, as an individual, can be a borrower of the Promissory Note, and state the very purpose of using these funds is to set up a business LLC. The debt of the Convertible Note is transferred to the LLC or Corporation once it’s been all set up. Once you set up the LLC, you are no longer personally liable for the debts – the LLC is.

What can I use the funds for?

Earnest Money Deposits: a deposit saying we want a right to buy the business/real estate at this later date.

Suitability: Does the Real Estate make sense for your own goals? You’ll often hire third-party inspectors/accountants to dig through the books and records to ensure it’s a good investment purchase. These expenses are contingent because they’re yours and the bank isn’t paying for them.

Legal Expenses: There’s always costs incurred in any merger acquisition transaction or by setting up your LLC properly working with your partners, creating service contracts or purchase agreements. If you’re raising funds from private investors, there’s often securities offering expenses and the composition of 100-200 page documents to legally be able to offer securities and raise capital from the masses.

Marketing Expenses: Business plans, email campaigns, and paying to go to networking events/conferences, there are often marketing expenses that come out of your pocket upfront.

Contingent Offerings

A Contingent Offering: Is when something needs to happen in order for a business/transaction to exist. When it comes to lenders, the contingency is ‘You will only use my money once you acquire the asset or fund the minimum business requirements.

• Convertible Notes very often work hand-in-hand with Contingency offerings and are often made for the specific purpose of paying for those high-risk expenses before you get to the closing table.

To ensure your business is safe, the key is to disclose, disclose, disclose. Disclose exactly what you believe is going to take place AND the risks relating to the transaction.

• For example, the risks of a convertible promissory note are that the asset doesn’t get closed, the funds don’t get raised, or it just doesn’t make sense for the transaction to move forward.

Conversion Options

Discount: Offering the convertible note holder (the private lender) a discount on investing into an offering or securities offering compared to any other investors.

Future Valuation or Sale Trigger: Either investor agrees to convert at a certain time or there can be an automatic conversion if the company gets a valuation of a certain level or an offer to buy/sell the company to/from a third-party.

• Ex: Trigger mechanisms if we get a value of $20 million. Investors will have to convert or agree to take a payout right now or within a designated time period.

Issue a Promissory Note: Issue a promissory note that goes along with an option, offering a designated price & time period that an investor is permitted to buy stock, or allowed to buy an interest in the company at that designated price.

Stock Options or Warrants: A contract that allows investors to buy a share of stock at a designated purchase price. These quickly becomes a very attractive option, especially if there are secondary markets.

• Options & Warrants are the same and most often used with public companies
• Ex: I borrowed $100,000 under a Convertible Note and am offered 20,000 stock options at $5 a share. The option holder’s $100,000 debt will accrue some interest and they have a right to buy 20,000 shares at $5 each. If I go to the market and sell shares at $6 a piece, the lenders are already in profit.

Untold Conversion: At the time a lender is ready to convert their stake from debt to equity in the company, there’s a written notice from the lender sent to the management. The internal records (ownership ledger) are updated and company provides an assignment/certificate.

• Most often, convertible notes have a 3-6 month to 3-5 year maturity date. If there is no conversion in that time, the payoff naturally has to happen at maturity and looks just like a conventional loan. If the lender does not take ownership as defined under the investment contract of the promissory note, they’re just operating like a lender and get their money back with whatever interest accrued.

Who will be my first lender?

Making sure your offering is NOT a security to start with, significantly minimizes risk.

•  Taking a large share of anybody’s net worth can result in external parties having additional rights to try to collect.
• State Attorney Generals often have the right to act on private lenders and interests in their behalf
• Attorney General or Secretaries of State often have the right to act against you.

Keep private lenders contributing below 20% of their net worth.

• Some state have set requirements that you cannot ask a private lender/investor for more than a set percentage of their net worth.

Accredited Investors: (a securities concept) If someone has a net worth greater than $1 million or they make more than $200,000 annually (or $300,000 including their partner), they are considered an accredited investor.
 

Convertible Note Template

[This section is not to be taken as legal advice, as I am not your attorney. You are being given general information and generic forms to do with whatever you’d like. It is ALWAYS best to have a qualified, competent attorney to help you along the way.]

1.    Instructions

2.    Loan Agreement

• Think of this section more like an investment contract. The investor is purchasing a promissory note directly from you or the company, which is an asset they own, which is why it’s a purchase agreement rather than an investment agreement

3.    The Promissory Note

• A one-page note that incorporates terms and conditions, interest rates and maturity date of the investment agreement. Signed by both company/borrower and lender, reflecting a debt holding by the lender and a debt obligation from the borrower.

4.    Conversion Election

• ‘I am electing to go ahead and convert my debt into equity’ – gives Investors the comfort of an easy conversion process.

5.    Lender Suitability

• Gathers information from the lender about where to make payments and their background, often called KYC: Know Your Client.