Raise Funds with Convertible Notes

Note: Want to skip the guide and go straight to the free templates? No problem - scroll to the bottom.
Also note: This is not legal advice.

Introduction

Raising funds has emerged as an increasingly popular route for people looking to get their start-up businesses off the ground, and many investors are turning to convertible notes as a way of doing just that. So what are the advantages of this financial instrument that make it such an attractive option?

At Genie AI, we believe that employing convertible notes comes with several unique benefits. Primarily, these debt instruments convert into equity at a later date, allowing those raising capital to benefit from both elements without taking on all the associated risks. For starters, they do not have to be immediately paid back like a traditional loan which gives issuers more time to reach their next milestone or goal before needing to worry about repaying the debt - plus the interest rate is usually lower than other options on offer.

Not only does this provide more flexibility for those in need of financing, but also offers more options for investors when it comes to the future of the company. Start-ups often don’t have enough cash flow in order to repay debt quickly so having this flexibility can be extremely helpful and can result in investors gaining an ownership stake in companies further down the line. Finally, convertible notes provide a higher return on investment and potential increase in equity value which presents great rewards if companies go on to be successful - while still offering protection against taking on too much risk by taking equity initially.

In conclusion then, choosing convertible notes over other forms of financing can prove very beneficial and profitable for all parties involved. With its flexible repayment terms, increased return on investment opportunities and future optionality; it’s no surprise that entrepreneurs and investors alike are recognising these advantages when looking to raise capital. At Genie AI we offer free template libraries so you can learn more about drafting your own legal documents right away - just head over there now!

Definitions (feel free to skip)

Contents

• Overview of Convertible Notes: What They Are, How They Work, and Benefits
• Understanding Convertible Note Basics
• Comparing Convertible Notes to Other Forms of Financing
• Legal Considerations: Understanding Convertible Note Terms and Structures
• Choosing the Right Jurisdiction
• Reviewing and Completing Legal Documentation
• Investor Perspective: Understanding Investors’ Needs and Expectations
• Determining Investor Suitability
• Understanding Investor Rights and Obligations
• Valuation: Setting an Appropriate Valuation for the Convertible Note
• Estimating the Pre-Money Valuation
• Calculating the Discount Rate and Conversion Price
• Negotiation: Structuring the Deal and Negotiating Terms
• Understanding the Negotiation Process
• Negotiating the Interest Rate, Maturity Date, and Other Terms
• Closing the Deal: Completing the Convertible Note Agreement and Closing the Deal
• Finalizing Documentation and Signatures
• Complying with Regulatory Requirements
• Post-Closing: Monitoring Performance and Ensuring Compliance
• Establishing a Reporting and Monitoring Process
• Ensuring Compliance with Regulatory Requirements

Get started

Overview of Convertible Notes: What They Are, How They Work, and Benefits

• Understand what convertible notes are, how they work, and the benefits of using them to raise funds
• Learn about the different types of convertible notes and their respective features
• Research and compare various convertible note providers to decide which one is the best fit for your business
• When you have a good understanding of convertible notes, the different types, and their benefits, you can check this off your list and move on to the next step.

Understanding Convertible Note Basics

• Learn what a convertible note is and why it is a popular form of financing
• Understand the key terms associated with a convertible note, including the conversion rate and discount rate
• Review the advantages and disadvantages of a convertible note
• Research relevant case studies and resources to gain a better understanding of how a convertible note works
• When you are comfortable with the basics of a convertible note and its associated terms, you can check this step off your list and move on to the next step.

Comparing Convertible Notes to Other Forms of Financing

• Understand the advantages and disadvantages of convertible notes compared to other forms of financing such as equity and debt
• Understand the impact of dilution that convertible notes will have on equity holders
• Analyze the liquidity, flexibility, and tax implications of convertible notes compared to other forms of financing
• Consider the different stages of your business and how convertible notes might be most suitable at different times

Once you have a good understanding of the advantages and disadvantages of convertible notes compared to other forms of financing, you can check this off your list and move on to the next step.

Legal Considerations: Understanding Convertible Note Terms and Structures

• Research the convertible note terms and structures available in the jurisdiction of your choice
• Draft and review the convertible note terms and structures with an experienced lawyer
• Understand the legal implications of the terms and structures you have chosen
• Once you have a clear understanding of the legal considerations, you can move on to the next step: Choosing the Right Jurisdiction.

Choosing the Right Jurisdiction

• Research potential jurisdictions to determine which one best meets the needs of your company and investors.
• Consider factors such as tax laws, regulations, and compliance requirements.
• Consult with a lawyer or accountant who is familiar with the jurisdiction to make sure you understand all the requirements.
• Once you’ve identified the jurisdiction that you’d like to use, you can move on to the next step.

Reviewing and Completing Legal Documentation

• Read through and understand all the necessary documents related to the convertible note
• Identify any potential risks that could arise from the terms of the note
• Work with a lawyer to create, review, and finalize the legal documentation
• Make sure to include provisions for conversion, maturity, and any other relevant details
• Once the documents are signed by both parties, the legal documentation phase will be completed and you can move on to the next step.

Investor Perspective: Understanding Investors’ Needs and Expectations

• Gather all relevant information about potential investors, such as their previous investments, risk appetite, and expected ROI
• Research potential investors to understand their motivations and expectations
• Consider what investors could gain from the convertible note, such as liquidity, and tailor your pitch accordingly
• Connect with investors and explain the opportunity in detail, including the terms and structure of the convertible note
• Negotiate terms and conditions as needed
• When you have finalised terms and conditions with investors, you can check this step off and move onto the next one

Determining Investor Suitability

• Research potential investors to assess their qualifications, including their experience, level of interest, and financial capacity
• Ask for a copy of their investor accreditation documents, such as a Form D or a Form S-1
• Review their past investments and analyze their risk appetite and expected return
• Evaluate the investor’s fit with the company’s goals
• Create a list of investors that meet the criteria and are likely to invest
• Contact investors to explain the convertible note offering and evaluate their interest

Once you have collected the necessary information and identified potential investors who meet the criteria, you can move on to the next step to understand investor rights and obligations.

Understanding Investor Rights and Obligations

• Research the federal and state laws that govern the sale of securities and the issuance of convertible notes.
• Understand the rights and obligations of the investors and the company, including the rules for converting the notes into equity.
• Make sure the investors have the necessary financial resources to purchase the notes and that their goals are in line with the objectives of the company.
• Draft terms in the convertible note agreement that clearly define the rights and responsibilities of the company and the investors.
• Consider obtaining legal advice on the appropriate language to use in the note agreement.

You can check this step off your list once you have fully researched and drafted the terms of the convertible note agreement, and you have considered obtaining legal advice.

Valuation: Setting an Appropriate Valuation for the Convertible Note

• Analyze the company’s past performance, future prospects and the current market conditions to set an appropriate valuation for the convertible note
• Review comparable funding rounds for similar companies and adjust for any differences
• Determine conceptually what the pre-money valuation should be, and negotiate with investors to get to a reasonable agreement
• Decide on a discount rate and interest rate to use for the note
• Document the valuation for the convertible note in the term sheet

You can check this step off your list when you have agreed on a reasonable pre-money valuation, discount rate and interest rate with the investors.

Estimating the Pre-Money Valuation

• Analyze the market, industry, and company’s financials to determine an appropriate range for the pre-money valuation
• Evaluate potential investors’ interest to determine what valuation terms may be acceptable
• Consider any relevant regulatory requirements for setting a pre-money valuation
• Utilize a financial advisor or other expert to calculate the pre-money valuation
• Once you have determined the pre-money valuation, you can move on to calculating the discount rate and conversion price.

Calculating the Discount Rate and Conversion Price

• Calculate the discount rate by dividing the interest rate by the pre-money valuation
• Determine the conversion price by subtracting the discounted value from the pre-money valuation
• Once you have the discount rate and conversion price, you can move on to the next step of negotiating the terms of the convertible note
• After completing the calculations, you should have a clear idea of the rate of return investors will receive and the price of the company’s stock that investors will receive once the note converts to equity

Negotiation: Structuring the Deal and Negotiating Terms

• Research the typical terms for convertible notes in your industry
• Create a term sheet for your convertible note with the discount rate and conversion price you’ve calculated
• Discuss the terms of the note with potential investors, and be prepared to negotiate
• Make sure you understand any potential legal and tax implications of the terms you agree to
• Reach an agreement on the terms of the convertible note, and sign the binding legal documents
• You’ll know you’ve successfully negotiated the terms of your convertible note and can move on to the next step when the documents have been signed by both parties.

Understanding the Negotiation Process

• Understand the different types of negotiations that can occur, such as back-and-forth negotiations, fixed-price offers, auction-style negotiations, and term sheets
• Identify the parties involved in the negotiation
• Set the goals and objectives for both sides
• Discuss the different terms of the convertible note agreement, such as the interest rate, maturity date, conversion rights, and other key elements
• Negotiate the terms of the convertible note agreement until both sides are satisfied
• Review and sign the convertible note agreement when both sides reach an agreement
• You can check this off your list and move on to the next step once both parties have agreed to the terms of the convertible note agreement.

Negotiating the Interest Rate, Maturity Date, and Other Terms

• Determine what the interest rate, maturity date, and other terms should be based on the current market conditions
• Negotiate the terms with the potential investor, ensuring that they are favorable to both parties
• Ensure that all terms are clearly defined in the convertible note agreement
• Check that all parties have agreed to the terms and sign the agreement
• You will know that you have completed this step when the convertible note agreement has been signed by all parties and the terms have been agreed upon.

Closing the Deal: Completing the Convertible Note Agreement and Closing the Deal

• Negotiate and agree on the interest rate, maturity date, and other terms
• Have a lawyer draft the Convertible Note Agreement
• Obtain all signatures required
• Ensure all necessary documents are in place
• Exchange funds and issue Note to Investor

You’ll know you can check this off your list and move on to the next step when all signatures are obtained, all necessary documents are in place, and the funds have been exchanged and the Note issued to the Investor.

Finalizing Documentation and Signatures

• Obtain signatures from all parties on the Convertible Note Agreement
• Ensure that all parties have received and signed copies of the agreement
• Record the executed documents on a company’s central repository
• Check that the closing conditions have been satisfied
• When all of the above have been completed, this step is finished and you can move on to the next step, Complying with Regulatory Requirements.

Complying with Regulatory Requirements

• Research applicable laws and regulations at the state and federal level that will apply to the fundraising effort, including securities and tax laws.
• Consult with legal counsel to ensure compliance with all necessary laws and regulations.
• Determine whether the fundraising effort is subject to state or federal registration requirements, and if so, ensure that the convertible note is registered.
• File any necessary registration documents with the applicable governmental agency in a timely manner.
• When all applicable laws and regulations have been complied with, you can proceed to the next step.

Post-Closing: Monitoring Performance and Ensuring Compliance

• Monitor the company’s performance over time to ensure it is meeting its goals
• Ensure the company is meeting the requirements of the convertible note, such as any milestones that need to be reached
• Create a reporting and monitoring process to track the convertible note’s status
• Establish a timeline for when to review the company’s performance and monitor the convertible note
• Make sure the company is staying compliant with all regulatory requirements
• Have a process in place to review the terms of the convertible note to ensure they are still valid

You can check off this step when you have established a reporting and monitoring process and timeline to ensure the company is meeting the requirements of the convertible note, as well as staying compliant with all regulatory requirements.

Establishing a Reporting and Monitoring Process

• Create a reporting system for tracking the progress of the convertible notes.
• Set up a timeline for when progress reports need to be sent to investors.
• Develop a method for collecting data and feedback from investors.
• Create a process for monitoring the performance of the notes.
• Establish a plan for responding to investor concerns.

Once you have established a reporting and monitoring process, you can move on to the next step of ensuring compliance with regulatory requirements.

Ensuring Compliance with Regulatory Requirements

• Research the applicable state and federal regulations for raising capital with convertible notes.
• Speak with a lawyer to ensure you are following all applicable regulations.
• Draft a disclosure document that informs potential investors about the terms of the convertible note.
• File the disclosure document with the appropriate state and federal governing bodies.
• Obtain any necessary licenses or permits from the government.
• Once the disclosure document has been filed and all necessary licenses and permits have been obtained, you will be able to move on to the next step.

FAQ:

Q: What is the difference between a convertible note and a bond?

Asked by David on 3rd June 2022.
A: Convertible notes are debt instruments which allow a company to raise money by selling debt which can convert into equity at a later date. Bonds are debt instruments which represent a loan to the company, with interest payments due for repayment at the end of the loan term.

Q: What is the difference between convertible notes and equity?

Asked by Isabella on 31st May 2022.
A: Convertible notes are debt instruments which give the holder the option to convert them into equity at some point in the future. Equity represents ownership in a company, usually in the form of shares. Whereas convertible notes give someone the option to convert their debt into equity, they do not confer any ownership rights until conversion occurs.

Q: Are there any specific requirements or restrictions when using convertible notes?

Asked by Joshua on 7th April 2022.
A: Yes, there are certain restrictions and requirements when using convertible notes. These may vary depending on jurisdiction and industry, but generally speaking they include restrictions on how much can be raised, how it can be used and who can invest in it. Additionally, there may be restrictions around who can hold convertible notes, how they can be transferred and how long they can last before being converted into equity or repaid.

Q: What are some of the advantages of using convertible notes?

Asked by Ava on 13th May 2022.
A: Convertible notes offer several advantages over traditional equity financing methods. Firstly, they are quicker to set up than other forms of financing, such as venture capital or angel investments. Secondly, convertible notes are often more flexible than other types of financing, as they allow for adjustments to the terms of the agreement if needed during negotiations. Finally, they can provide an extra layer of protection for investors by allowing them to convert their debt into equity if certain conditions are met at a later date.

Q: Are there any tax implications when using convertible notes?

Asked by Ethan on 2nd February 2022.
A: Yes, there may be tax implications when using convertible notes depending on where you are based and your individual circumstances. Generally speaking, investors may be liable for capital gains tax if their note is converted into equity at a higher value than what it was purchased for. Additionally, companies issuing convertible notes may also have to pay taxes depending on their jurisdiction and any agreements with investors. It is important to consult with a qualified tax advisor when considering issuing convertible notes to ensure compliance with applicable laws.

Q: How do I determine the value of my convertible note?

Asked by Emma on 27th March 2022.
A: The value of your convertible note will depend on several factors such as the amount invested, the current market conditions and any agreements made with investors. Generally speaking, it is based on an estimated future value of your company’s equity at some point in the future (usually after an exit or IPO). This estimated future value is then used as a basis for calculating the current value of your note’s conversion rate (the percentage of shares you will receive if it is converted into equity). It is important to ensure that you understand all elements of your agreement before issuing any convertible notes so that you can accurately calculate their current value and ensure that you remain compliant with applicable laws and regulations.

Q: What happens if I don’t meet my obligations under a convertible note agreement?

Asked by Noah on 11th January 2022.
A: If you do not meet your obligations under a convertible note agreement then you may be in breach of contract and could face penalties from investors or other parties involved in the agreement. Depending on your individual circumstances, this could include anything from having to pay back part or all of the funds invested to facing litigation for damages caused as a result of your breach of contract. It is important to make sure that you understand all aspects of your agreement before entering into one so that you can ensure that you don’t inadvertently breach it in future.

Q: How do I structure my convertible note agreement?

Asked by Liam on 18th December 2021.
A: Structuring your convertible note agreement correctly is essential to ensure that it meets all relevant legal requirements and protects both parties involved in the transaction. Generally speaking, it should include details such as the amount being raised, when repayment will be due (if applicable), what will happen if repayment isn’t made (e.g., penalties or litigation), who will have voting rights (if applicable), what type of security will be provided (if applicable) and what restrictions will apply (e.g., transferability). Additionally, it should also detail any special provisions that may apply such as anti-dilution protection or pre-emption rights for existing investors or shareholders. It is important to consult with legal advisors before entering into an agreement so that you can ensure that all aspects have been considered and addressed correctly.

Q: What is anti-dilution protection?

Asked by Abigail on 23rd October 2021.
A: Anti-dilution protection is a clause often included in convertible note agreements which protects early investors from dilution caused by subsequent investment rounds at lower valuations than originally agreed upon with earlier investors/shareholders (i.e., dilution). It typically works by adjusting the conversion rate of early investors/shareholders so that they receive more shares than they would have otherwise received without anti-dilution protection clauses in place — this helps protect their investment and gives them more control over company decisions going forward as their shareholding increases proportionally with subsequent investments rounds at lower valuations than originally agreed upon with earlier investors/shareholders (i.e., dilution).

Q: How do I negotiate terms with prospective investors?

Asked by Carter on 8th November 2021 .
A: Negotiating terms with prospective investors can be an important part of securing investment for your company through issuing convertible notes because it allows you to tailor terms which suit both parties’ needs as well as ensuring compliance with relevant regulations and laws in your jurisdiction(s). Generally speaking, negotiations should focus around topics such as valuation, conversion rate(s), maturity date(s) & payment terms, anti-dilution protection clauses & pre-emption rights for existing shareholders/investors as well as other restrictions and obligations which may apply depending on your particular circumstances (e.g., transferability). It is important to ensure that both parties understand all aspects of any agreements prior to signing them in order to protect everyone’s interests going forward

Example dispute

Suing a Company Over a Convertible Note

• A plaintiff might raise a lawsuit when a company has failed to meet the terms of a convertible note agreement.
• The lawsuit could include references to the terms of the convertible note, including the maturity date, the interest rate, the conversion rate, and any other conditions of the note.
• The plaintiff could claim that the company has violated the terms of the convertible note agreement and is seeking damages or other remedies.
• The plaintiff may also include references to relevant civil and securities law that the company has violated, such as the Securities Act of 1933 or the Sarbanes-Oxley Act.
• The plaintiff may also allege that the company has failed to disclose material information about the convertible note, such as the terms or the conversion rate, or that the company has engaged in fraudulent activities related to the note.
• The plaintiff may seek compensatory damages or other remedies, such as a court order to compel the company to comply with the terms of the convertible note agreement.
• The plaintiff may also seek punitive damages, if the alleged violations of the note agreement were egregious or the company acted with malicious intent.
• Settlement of the lawsuit could involve payment of damages, restitution, or other remedies as agreed upon by both parties.
• The court may also order the company to provide an accounting of all of its convertible notes, as well as any other documents related to the notes.
• If damages are awarded, they may be calculated based on the terms of the convertible note, such as the amount of interest or principal due, or the value of the note at the time of the alleged breach.

Templates available (free to use)

Convertible Note Agreement
Convertible Note Financing Seed Stage Startup Term Sheet
Convertible Note Purchase Contract With Short Form Note Seed Stage Startup
Form Of Convertible Note
Side Letter Convertible Note Financing Seed Stage Startup
Stand Alone Convertible Note Seed Stage Startup
Subordinated Convertible Note

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