Convertible loan notes can be explained as short-term debts that can be converted into equity-share in the future. With these notes, one can invest in start-ups and receive discounted share prices of the same company, depending on their future valuation.
Initially, an investor gives the notes as a loan to the company that can convert to an equity share in the future. The price of the share is not predetermined; neither it is defined at the time of investment.
In this article, we will discuss the ins and outs of convertible notes so that you can make an informed decision about whether or not you should use them for investment.
Convertible loans v.s ordinary loans
To understand the features of convertible loans, firstly, you should know the difference between them and ordinary loans. The convertible loans/debts have a standard loan’s security and characteristics until it gets converted into equity. The borrower is obliged to pay the principal and interest to the lender according to the loan terms. The default policy will also be followed when either party fails to follow the loan agreement’s terms.
Features of the convertible loan
Now let us discuss some of the unique features of convertible loans which interest people to invest in high-risk ventures using it:-
- For convertible loans, interests are needed to be paid at maturity or in equity during conversions.
- There are mandatory conversions of these debts, which ensures the loan automatically becomes converted to equity on a specific event.
- The lender might also negotiate an optional conversion right, which states that the lender might convert the debt to equity depending on its preferred economic outcomes.
- The notes’ conversion price is typically based on the discount rate or valuation cap decided at the time of lending.
- The lender’s discount helps him acquire more equity on conversion than what he would get if he purchased the equity without a discount.
- The valuation cap is the dollar ceiling at which investors convert their loans to equity.
Convertible notes are very flexible. Lenders are at risk with this type of loan, but they can, of course, liquidate the company’s asset in case of no repayment. The process involves many documentations like note purchase agreements and other ancillary documents that might affect investors’ rights. Before you invest, hire an attorney experienced in this field to help you out.