Convertible note

curl -X POST https://dealroom.todo.law/api/v1/agent/contracts \
  -H "Authorization: Bearer drk_YOUR_KEY" \
  -H "Content-Type: application/json" \
  -H "Idempotency-Key: $(uuidgen)" \
  -d '{
    "contractType": "CONVERTIBLE_NOTE",
    "governingLaw": "ENGLAND_WALES",
    "language": "en",
    "party": {
      "legalName": "Your company"
    },
    "counterparty": {
      "legalName": "The other company"
    },
    "terms": {
      "principal-amount": "10000",
      "valuation-cap-amount": "10000",
      "qualified-financing-threshold": "10000"
    },
    "inline": "md"
  }'

What it is and when it is used

A convertible note (convertible promissory note) is a short-term loan made by an investor to a start-up as part of seed-stage financing. The company promises to repay the principal with interest, but the parties intend that the loan will instead convert into equity when the company raises a proper priced round, called a qualified financing.

It is used when a company needs money before it is ready to agree a valuation. The note postpones the valuation question to the next round, while giving the early investor a better price than new investors through a valuation cap, a discount, or both. Until conversion, the investor is a creditor, not a shareholder: the note gives no voting rights, no dividends and no share in liquidation distributions, except as the note itself provides.

Who signs it and in which role

• The Company, the start-up that issues the note and borrows the money.
• The Investor (also called the Holder), who lends the principal.

Notes are often issued in a series to several investors. Holders of more than 50 percent of the principal of the series (the Majority Holders) can agree amendments and waivers with the Company that bind every holder.

Key clauses

The skill negotiates 11 clauses, all of them required.

Principal amount and interest rate

You enter the principal amount. Interest accrues but is not paid in cash; it is added to the principal and converts with it. The options are 5 percent simple interest, 8 percent simple interest, or no interest, in which case the investor's return comes only from the cap and discount.

Maturity date

This is the outer limit of the note: if it has not converted by then, it falls due. The options are 18 months (extendable by up to six months with the Majority Holders' consent), 24 months, or 12 months with a commitment to use reasonable efforts to close a qualified financing.

Valuation cap

The cap is a maximum pre-money valuation used to set the conversion price. You enter the cap amount. The options are a standard pre-money cap, a higher cap reflecting strong traction, or no cap, in which case conversion is at the round price less any discount.

Conversion discount

The discount reduces the price the noteholder pays compared with new investors: 20 percent, 15 percent, or none. When both a cap and a discount apply, the noteholder converts at whichever gives the lower price.

Qualified financing trigger

This is the minimum size of equity round that triggers automatic conversion, excluding money from the notes themselves. You enter the threshold in the currency of the note; the options recommend 1,000,000 (the market standard in the skill), 500,000 or 2,000,000.

Conversion mechanics

The note can convert into the same series of preferred shares sold to new investors, with identical rights; into a separate "shadow" series with similar terms but a liquidation preference equal to the conversion price; or into common shares with no preferred rights.

Treatment at maturity

If no qualified financing occurs, the note can convert automatically at the valuation cap, the Investor can elect between cash repayment and conversion (converting automatically if no election is made in time), or the full amount must be repaid in cash, with failure to pay being an event of default.

Liquidity event before conversion

If the company is sold or goes public before the note converts or is repaid, the Investor can choose between a cash payment of 1x the conversion amount and conversion at the cap price just before the event (the market standard in the skill); can take 2x the conversion amount in cash, which the skill flags as non-standard; or the note simply converts into common shares at the cap price, with no cash multiple.

Prepayment rights

Prepayment can remove the investor's chance to convert. The Company may be barred from prepaying without consent, may prepay in full only with the Investor's consent and a premium, or may prepay in full at any time on notice with a premium. You enter the premium percentage, 5 percent by default.

Information rights

While the note is outstanding, the Company provides quarterly unaudited financial statements plus a short business update, annual financial statements only, or no contractual information at all.

Subordination and priority

The note can rank behind senior bank debt but equally with other convertible notes, ahead of all debt incurred after it, or behind all other debt, ahead only of shareholders.

Standard terms also cover events of default, securities law restrictions on transfer, the absence of shareholder rights before conversion, a waiver of formal demand for payment, and amendments agreed by the Majority Holders.

What the two sides usually negotiate

The Company wants low dilution, time and flexibility; the Investor wants a good conversion price, protection of the right to convert, and a way out if the company does not raise. Dealroom proposes the balanced positions in the skill as the middle ground when the two sides disagree:

• Maturity: 18 months, with a six-month extension by Majority Holder consent.
• Valuation cap: a standard pre-money cap.
• Discount: 20 percent.
• Qualified financing: a 1 million minimum raise.
• Conversion: into the same series as new investors.
• Sale before conversion: the Investor's choice between a 1x cash payment and conversion at the cap.
• Prepayment: only with the Investor's consent, plus a premium.
• Information: quarterly financial reports.
• Priority: behind senior debt, equal with other notes.

The most contested points sit at the extremes. No valuation cap leans strongly towards the Company; a 2x cash-out on a sale strongly favours the Investor, and cash repayment at maturity and a ban on prepayment also favour the Investor. On interest no option is neutral: 5 percent simple, the market standard described in the skill, is closest to the middle and leans slightly to the Company; zero interest favours the Company more and 8 percent favours the Investor. At maturity, giving the Investor the choice between cash and conversion sits closest to the centre.

Jurisdictions and languages Dealroom supports for it

Dealroom offers the convertible note for California, England and Wales and Spain, drafted in English or Spanish.

• California: California law and the courts of San Francisco County. The note aims to use the usury exemption in Corporations Code section 25118 where its conditions are met; otherwise the constitutional ceiling applies, which the skill gives as the higher of 10 percent or five points over the San Francisco Federal Reserve discount rate. Because pre-dispute jury waivers are unenforceable in California, the note contains none; instead either party may refer a dispute to a judicial referee.
• England and Wales: structured as a convertible loan note; conversion is by allotment of new shares under the Companies Act 2006, subject to section 561 pre-emption rights, and the Company confirms its authority to allot. Interest is subject to UK tax, and liability for fraud is preserved.
• Spain: structured as a préstamo convertible; conversion into participaciones sociales is a capital increase by set-off of credits (article 301 LSC), approved by the general meeting with a report from the directors. Because the law requires the credit to be fully due, every conversion option brings the note's maturity forward to the moment of conversion. Under the registry doctrine cited in the skill, the statutory pre-emption right of article 304 LSC does not arise in an increase by set-off, so no waiver is needed, although the articles may grant a wider right and abusive dilution can still be challenged. Interest must respect the 1908 usury law, the Company withholds tax on interest, and disputes go to the courts of the company's registered office.

Common mistakes

• Leaving prepayment open. Without restrictions, a company could repay just before a high-valuation round and remove the investor's conversion.
• Choosing cash repayment at maturity without a plan. The skill describes repayment demands as a route to insolvency for a start-up.
• Setting the qualified financing threshold badly. Too high delays conversion; too low allows conversion on a small round that does not really validate the price.
• Ignoring usury and tax rules. Interest must stay within usury limits; zero-interest notes can lead to imputed interest for tax purposes.
• No information rights. Noteholders are creditors with limited statutory information rights, so contractual reporting is their main source of information, and in Spain the member's right to information only applies after conversion.
• Forgetting the corporate steps. In England, conversion needs authority to allot and attention to pre-emption rights. In Spain, it needs a general meeting resolution and the directors' report, and the note must fall due at conversion; creating a separate "shadow" class also requires amending the articles.