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Convertible note financing

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Before investing in a company, clients often ask us if they should make a convertible note investment and what the difference is between convertible note financing and equity financing.

Equity financing is simply the subscription for shares in a company.  The shares issued may be ordinary shares or another class of shares such as preference shares.  Equity financing is the simplest and most straightforward form of investment into a company.

Convertible note financing involves the issue of “convertible notes” by a company to an investor.  A convertible note is a debt owed by the company to the investor which the investor at a point in time may convert to shares.  Each convertible note represents an amount of debt owed by the company to the investor.  The amount of the debt is called the “face value” of the note.  For example, if a company issues convertible notes at a face value of $100, then that will represent a debt of $100 owed by the company to the investor for each note issued.

Convertible note financing is more complicated than equity financing however provides the investor with significant leverage.  It allows the investor the flexibility to initially start their relationship with the target company as a lender with all the powers that come with that relationship.  If the investor then believes at a future point in time that the company’s prospects warrant an equity investment, then the investor may convert the debt the company owes it into shares in the company.

Convertible notes also require additional regulation under the Corporations Act.  Under certain conditions, the issue by a company of convertible notes may require formal disclosure and an offer document.  Further, the Corporations Act may require that the convertible notes are held by a trustee on behalf of all note holders.

If you are contemplating a convertible note investment into a company then there are a number of issues you need to consider.  These include:

  • The terms of the loan.  For example, what interest rate should apply?  When will interest be paid?  Will the loan be secured by a charge over the assets of the company?
  • The type of shares to which the loan may convert.  It is common to convert the debt owed to ordinary shares but we often see preference shares being issued on conversion.
  • The conditions which must be met for the conversion to equity to occur.
  • Whether under certain conditions conversion to equity can occur automatically.
  • More complicated factors such as anti-dilution protection, discounts on issue, voting rights and information rights.

Convertible note financing and straight forward equity financing are only two of the available methods of investing into a company.  Before making an investment, advice should be sought on the suitability of the investment and the legal obligations that attach to it.   Appropriate levels of due diligence should be conducted in all cases.

If you have any questions regarding your investment options and related legal obligations, please don’t hesitate to contact one of our Corporate Advisory lawyers for a confidential discussion.

Author:  Darren Sommers

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