Venture Financing Tips: Conversion of Notes

Hear from Jesse Jones, Fourscore Business Law Founder, about Convertible Notes. In this video, Jesse explains the conversion of notes. He discusses auto-conversion, option conversion, and shadow series of preferred stock as they relate to Convertible Notes. Stay tuned for the next video in our Venture Financing Tips series and subscribe to our monthly newsletter full of resources here.

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Venture Financing Tips: Conversion of Notes

Hi, I'm Jesse Jones, founder of Foursquare Business Law. Thanks for tuning into this quick video on convertible notes. This video we're going to cover conversion of notes, specifically three items.

Automatic conversion, optional conversion, and essentially what is it converting into. So shadow series preferred stock is what we're going to talk about. Automatic conversion means that at a certain point those notes that you sold are going to convert into stock.

And most normally that is tied to what we call qualified financing amount. So let's say it's a million dollar qualified financing. If you as the CEO of the company go raise a million dollars or more, then the notes you previously sold are going to automatically convert in that financing.

If you have a million dollar qualified financing amount, and you the CEO go raise $800,000, then those notes are not going to automatically convert. Now, optional converting comes into play in two spots. The first one is the situation I just described, where you have a qualified financing of a million dollars, but you actually go raise money in an amount of $800,000 or something less than a million dollars.

The notes don't automatically convert, but in many cases, the note holders are happy to, or maybe want to convert into that financing. It requires their consent, but most normally they're allowed to do that if they would like to. The other spot where optional conversion comes into play is at maturity.

So let's say it's a 12-month maturity date. You get to your end of the maturity date, and the note is now due. A lot of times entrepreneurs don't really realize that a convertible note is actually debt.

There is a repayment obligation. It very, very rarely ever actually comes into play, because after that year, that maturity date is up, normally one of two things is going to happen. One, either the company has no money and it really can't repay it, and so it gets extended, the maturity date gets extended.

Or number two, potentially the investor says, you know what, I'm okay converting into common stock at a preset valuation. And so that preset value is likely in the note, or it could be negotiated at the time. But that's where optional conversion comes into play in a convertible note.

Now, what does a convertible note convert into? Well, it could convert into almost anything. But in most scenarios, it's going to convert into the shares that are sold at the next financing, at the qualified financing where conversion is automatic. And so that could be exactly the same shares.

It could be all the same rights, the same liquidation preference, the same conversion price. Everything is exactly the same as it's being sold. Or it could convert into what's called a shadow series of preferred, which would basically be exactly the same as everything that is being sold in the next financing, except for they're going to take into account the discount on the note when it's converted into shares.

And that would affect the amount of liquidation preference and the conversion price in the charter. We spoke about liquidation preference in an earlier video. So please check out all our videos on equity financing and venture financing.

For more information on convertible notes, check out our white paper on venture financing at forscorelaw.com. Thank you.

Common Questions About Venture Financing Tips: Conversion of Notes

• Q: What is automatic conversion in a convertible note?

  A: Automatic conversion means your convertible notes turn into stock when you raise a set amount of money, called a qualified financing amount. For example, if that threshold is $1 million and you raise $1 million or more, the notes convert automatically.

• Q: What happens to a convertible note when it reaches its maturity date in North Carolina?

  A: When a convertible note matures, the company either extends the maturity date (if it can't repay) or the investor agrees to convert the debt into common stock at a preset valuation. Repayment is rarely required in practice.

• Q: Can convertible note holders convert their notes if the funding round falls short of the qualified financing amount?

  A: Yes — note holders can optionally convert into that smaller financing round with their consent, even if automatic conversion wasn't triggered. This optional conversion gives investors flexibility when a raise falls below the required threshold.

• Q: What does a convertible note actually convert into?

  A: A convertible note typically converts into the same shares sold in the next qualifying financing round. It may convert into a "shadow series" of preferred stock that reflects any discount the note holder earned, which affects their liquidation preference and conversion price.