One way for a startup to raise capital is to issue a convertible note to investors.
These investors loan the company funds and have a right to recover their loan amount - usually with interest - and convert it into shares - usually at a discounted rate- when certain pre-agreed trigger events occur.
Now the question is when does the conversion take place? And what are the events that trigger this conversion?
Convertible notes will typically convert into shares or be subject to repayment upon 3 types of events:
1- The maturity date
2- A qualifying financing
3-Or an exit event
The Maturity Date is a pre-agreed date on which the loan amount must be repaid or converted if another trigger event has not occurred
If a qualifying financing or exit event does not occur before the maturity date, a noteholder can choose to either recover their loan amount or convert their loan amount into shares.
If the noteholder decides to convert the loan into shares, the company will have to determine the noteholder’s number of shares by dividing the loan amount, plus any accrued interest, by a certain share price.
A pre-agreed method of calculation set out in the convertible note terms will determine this share price.
A Qualifying Financing is when the company raises a round of equity investment through the issue of shares to investors
If there is a qualifying financing, convertible notes will automatically convert into new shares.
The company should calculate the number of shares to be issued to the noteholder on top of the company’s existing shares, and state the method used to calculate that number – we will dive into this in our next video.
In a nutshell, the calculated price per share will determine the number of shares converted.
One thing to keep in mind is that the convertible note discount rate allows the noteholder to convert at a lower price per share.
And in the case where the convertible note includes a valuation cap, the price per share used for the conversion could be determined by reference to the valuation cap if it results in a lower price than the discounted price.
Finally, an Exit Event is when a company sells its shares and assets
The terms of your convertible notes will usually require the company to notify the noteholder and the noteholder can choose either to recover or convert, just like converting at the maturity date.
If the noteholder chooses to convert, the noteholder number of shares will be determined by dividing the loan amount- plus any interest- by the agreed share price, which is typically the fair market value of an ordinary share in the company at the time of the exit event.
Again, in case the note includes a discount rate or valuation cap, the share price will be calculated in reference to whichever generates a lower price per share.
In conclusion, keep these 3 conversion events in mind if you are raising capital using convertible notes, and understand their consequences.
Next, we’ll look into the conversion methods that can be used to convert convertible notes, starting with the “Pre-Money Conversion Method.
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