4 Steps in Making a Convertible Note Agreement

A convertible note agreement is a term sheet that acts as a no-strings-attached agreement between investors and a startup.

Before making a deal with your initial investor for funding in exchange for a convertible note, you need to make sure that some terms are clear. This is where you need a convertible note agreement. A convertible note agreement is a term sheet that acts as a no-strings-attached agreement between investors and a startup. This non-binding agreement is made before the final investment contract is created. It is important that both parties have a clear understanding of the commitment involved in the contract.

What is a Convertible Note Agreement?

A convertible note agreement is a record or a deal for an investor to subscribe to convertible notes (a debt instrument that converts into equity under predetermined circumstances). Simply put, once the parties involved have finally reached an agreement, a set of more detailed non-binding contracts and legally binding documents are prepared and signed.

One condition that helps convert a convertible note into equity under a Convertible Note Agreement is qualified financing at a liquidity event or at the maturity date.

To raise funds by issuing convertible notes, one can use either a convertible note agreement or a convertible note instrument. Also, one may use a convertible note agreement if a company has one (or very few) investors subscribing for the note.

A convertible note is not exactly the same as the Simple Agreement for Future Equity (SAFE). In fact, SAFE is created with a convertible note agreement. It comes with clauses of the amount, has a minimum amount of funds to be raised, and comes with a maturity date.

Why is a Convertible Note Agreement important for a company?

A convertible note agreement is an important document for a company because the terms and conditions of the final legal agreement are based on this initial agreed-upon document. A convertible note subscription letter is given to each investor as proof that defines the amount of convertible note the investor will subscribe to and pay. This letter also demands to be countersigned by the organization to confirm acceptance.

Who should use the Convertible Note Agreement?

Convertible notes are excellent for new companies that are in high-development stages. The organization ought to talk to potential investors for seed funding to have a valuation and convertibles whenever the company needs them.

Convertible notes are nothing but debt before they are transformed into equity. The organization should develop quickly and towards an evaluated round for the notes to make an incentive for financial backers. If this doesn’t occur quickly enough and the note matures, the organization might need to take care of the obligation with interest if the investor does not extend the maturity date.

Convertible notes are likewise excellent for new businesses that need to get financing rapidly. Since the convertible note is simply a loan, all you need is a promissory note to push ahead with the arrangement, unlike a standard equity agreement which includes a detailed term sheet.

Tracking down the right financing is one of the main tasks for any new company. Convertible notes are helpful in the beginning phase of organizations, yet they should know the terms. An agreement legal advisor can assist you with setting up a convertible note and feel sure about your choice. Before you get into an agreement, it’s important to understand the pros and cons of a convertible note agreement.

Pros and Cons of Convertible Note Agreement

Pros and Cons of Convertible Note Agreement

The Pros of Convertible Notes:

  • Convertible note financing is less difficult to achieve according to a legal viewpoint, implying they are more affordable and faster to implement.
  • Convertible notes try not to put a valuation on the startup, which can be helpful, especially for seed-stage organizations who don’t have sufficient working history to set a valuation appropriately.
  • These notes are good bridge-capital or intra-round financing choices.

The Cons of Convertible Notes:

  • If future value adjustments are not finished, the convertible note will remain as a debt and subsequently require recovery. This might drive organizations to bankruptcy.
  • To keep away from the terms and conditions, whenever taken excessively far, nullifying the purpose of the convertible note winds up taking as much time and exertion as a regular value round.
  • Specific clauses, for example, the valuation cap and the conversion discount, complicate the future value raises by securing value assumptions.

Important Terms in a Convertible Note Agreement

Certain core terms will be included in a term sheet for a convertible note. Here are some of the core terms that will fit in a term sheet for a convertible note:

Important Terms in a Convertible Note Agreement

  • Financing Amount – It’s the capital a startup raises through the convertible debt offering. In a term sheet, this field characterizes the maximum amount if investors pre-fill the sheet.
  • Closings – Investment negotiations may occur in multiple closings, and so, this field defines a specific date.
  • Maturity Date – Convertible notes contain a maturity date, and it is the date on which one must repay the notes with interest.
  • Conversion Price – It’s the price per share at which one can change convertible security into common stock.
  • Valuation Cap – The valuation cap is an additional reward for bearing any prior danger or risk. It adequately covers the cost at which your notes will change over into equity and provides convertible noteholders with value like potential gain if the organization takes off from the gate.
  • Prepayment – This field characterizes whether the startup can prepay the convertible notes without the permission of the convertible noteholders. As clarified, the two parties should agree on each term; and should have a similarly adequate understanding.
  • Fees and legal expenses – The two parties approve the legal and other additional costs brought about in the transaction. Each of the terms that are shared in the agreement is non-binding. There is only one term that is legally binding and that both parties agree on is the confidentiality of the agreement. It means that the terms and information that you have included in the agreement cannot be disclosed to any third party until you have the consent of all parties involved.

How does Convertible Note Agreement work?

The convertible notes have a term sheet that acts as a non-binding agreement used for both the startups and investors. This term sheet is used during the funding round, and it acts as the base of all legally binding documents that are used in the future. It works only when both parties come to an agreement about this. This financial instrument assists both parties to conduct a more factual discussion, about their legal commitment and expectations. It is advised that you seek help from a qualified lawyer who can prepare the agreement for both parties.

Steps to create a Convertible Note Agreement

Here are the steps for you to develop your own convertible note agreement:

Step 1: Open negotiations

One might make a Convertible Note Term Sheet to promote discussion and negotiation with their investors. A term sheet is an uncomplicated and easy-to-read document, which is not legally binding.

Step 2: Creation of the convertible note

The creation of convertible notes demands approval at both the board and shareholders’ levels. Direct your company secretary to develop the appropriate minutes or written resolutions to record such consent. Execute the Convertible Note Instrument as a deed. Remember to always check your Articles of Association for the need to execute a deed, or consult your company secretary accordingly.

Step 3: Subscription by investors

Develop the Convertible Note Subscription Letter for each investor to mark which amount of convertible note he will contribute to and how he will pay. Each investor will perform a separate letter. This letter requires to be countersigned by the company that will confirm the acceptance.

Step 4: Completion of subscription

As soon as the investor pays the principal amount to the company, they will then issue the Convertible Note Certificate for the investor. This certificate has to be then executed as a deed.

Convertible Note Agreement Template

Looking up a convertible note agreement template online will lead you to all sorts of documents that are used by incubators, VC companies or law firms.

The proper template to use is by the Secretary of State, which can be found here.

Manage your Convertible Note Agreement with Eqvista

Creating a Convertible Note Agreement can be stressful and daunting, which is why the best way to handle this is by using Eqvista. It will help you save a lot of time by easily preparing the agreement online and save your progress. Once you have done this, you can then move ahead and issue the convertible notes directly. Check out the support article on how to create a convertible note here!

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