There are several ways a startup can raise capital. One way is to issue convertible notes to investors. In exchange, those investors loan the company funds. Convertible notes give investors a right to recover their loan amount (usually with interest) or have their loan amount (and any interest) convert into shares when certain pre-agreed trigger events occur. 

To reward the investor, the terms of convertible notes may include a discount to the market value of a share at conversion. This allows the investor to receive shares at a lower price than what they are worth.

Using convertible notes to raise capital is attractive to startups because it can be simpler and quicker than an equity investment. It also saves the company from having to issue shares to investors, and therefore negotiate a valuation, upfront. However, convertible notes may convert into shares at some point. It is important to understand the: 

  • consequences of this; and 
  • practical steps your company must take when this happens.

Convertible Notes on the Cap Table

Convertible notes will convert into shares (or be subject to repayment) at predetermined trigger events. These trigger events are usually:

  • the maturity date (when the loan amount must be repaid or converted if another trigger event has not occured);
  • a ‘qualifying financing’ (where the company raises a round of equity investment through the issue of shares to investors); or
  • an ‘exit event’ (where a company sells its shares and assets or lists on a stock exchange).

When using convertible notes, your investors do not receive shares upfront.They are therefore noteholders rather than shareholders. However, they will receive shares if their convertible notes convert. Therefore, it is important to carefully consider the effect of convertible notes on your company’s cap table. You should also note that your convertible notes may attract interest. If this is the case, the amount that will convert is generally not just the original loan amount.

For example, when you are considering undertaking a qualifying financing, you will need to prepare a capitalisation table that shows what the company’s share structure will look like after the qualifying financing is complete. In this capitalisation table, it is important to show the:

  • new investors being issued shares as part of the qualifying financing; and 
  • shares which will be issued to your noteholders upon conversion of their convertible notes. 

This allows you to consider the potential dilutive effect of the noteholder conversions on the existing shareholders’ shareholdings. In turn, this may affect how much of the company you are willing to part with in your qualifying financing. Your new investors will also want to understand the effect of noteholder conversions. This is because this impacts how much of the company they will own after the qualifying financing is complete.

Conversion at the Maturity Date

If a qualifying financing or exit event does not occur before the maturity date, a noteholder can usually choose to: 

  • recover their loan amount (plus interest); or 
  • convert their loan amount (plus interest) into shares. 

If the noteholder does not make a choice within the required time frame after the maturity date, the convertible note terms will usually outline an automatic result. Typically, the result is that the amount will convert to shares. 

If the convertible notes convert into shares, the company will need to determine how many shares to issue to the noteholder. To do so, the company will usually divide the loan amount, plus any accrued interest, by a certain share price. A pre-agreed method set out in the convertible note terms will determine this price.

For example, the share price could be decided by an independent valuer based on the fair market value of the shares at the maturity date. 

You will also need to determine the class of shares to issue to the noteholder. Conversion at the maturity date will usually require the company to issue the noteholder with the highest class of shares on issue at the time. 

For example, if the company has ordinary shares and preference shares on issue, then the noteholder will generally be issued preference shares.

Conversion at a Qualifying Financing

If there is a qualifying financing, convertible notes will usually automatically convert into shares. The terms of your convertible notes may require you to give your noteholders written notice, often referred to as a ‘conversion notice’. This notice states the company’s intention to issue the noteholder with shares as a result of the qualifying financing. The conversion notice should also set out:

  • the number of shares to be issued to the noteholder; and 
  • how the company should calculate that number of shares.

To determine the number of shares to issue to the noteholder as a result of the conversion, you will need to divide the loan amount (plus any accrued interest) by a certain share price. This share price is generally the share price of the qualifying financing, subject to a discount for the noteholder. This discount allows the noteholder to convert at a lower share price. Therefore, the noteholder gets more shares for their money. 

However, if the convertible notes includes a valuation cap, the share price used for the conversion could be determined by reference to the valuation cap if this results in a lower share price than the share price in the qualifying round (applying any discount).

For conversion at a qualifying financing, the terms of the convertible notes will usually require the company to issue to the noteholder the class of shares it issues as part of the qualifying financing. 

For example, if the company is undertaking a seed round of equity investment where it issues ‘seed preference shares’, the noteholder would also receive ‘seed preference shares’.

Conversion at an Exit Event

The terms of your convertible notes will usually require the company to notify the noteholder prior to entering into documents to give effect to an exit event. Usually, the noteholder can choose whether they want to: 

  • recover their loan amount (plus any interest) in cash; or 
  • convert that amount into shares.

If the noteholder chooses to convert their convertible notes, the company will determine the number of shares to be issued to the noteholder by dividing their loan amount (plus any accrued interest) by the agreed share price. That share price is generally the share price related to the exit event (typically the fair market value of an ordinary share in the company at the time of the exit event), subject to a discount for the noteholder. Again, however, if the convertible note includes a valuation cap, the share price used for the conversion could instead be determined by reference to the valuation cap if this is better for the noteholder.

For conversion at an exit event, the company will issue ordinary shares to the noteholder. This means that the noteholder is treated like other ordinary shareholders as part of the exit event.

Issuing Shares Upon Conversion

When your convertible notes convert, the company will need to undertake a number of steps in order to issue shares to the noteholder. 

The company will need to approve the issue of shares to the noteholder. Usually, the directors do so by passing a board resolution. Depending on the terms of your company’s shareholders agreement, you may also need to obtain shareholder consent to the issue of shares to the noteholder. Where the conversion is occurring because of a qualifying financing or exit event, you can often incorporate these approvals as part of the approvals for the qualifying financing or exit event.

Your investor will need to sign the company’s shareholders agreement, or a deed of access to the shareholders agreement, if there is one.

Lastly, the company will need to: 

  • update its register of members to record the shares; and
  • update its register of noteholders recording that the notes have converted. 

The company will then: 

  • cancel the noteholder’s note certificate; 
  • give the noteholder a share certificate for their new shares; and 
  • notify ASIC that it has issued the shares.

Key Takeaways

If you are raising capital using convertible notes, you need to consider the consequences of those convertible notes converting. You should understand:

  • the trigger events which give rise to conversion (i.e. a qualifying financing, exit event or reaching the maturity date); 
  • how you will calculate the number of shares to issue to the noteholder;
  • the effect of any accrued interest on the number of shares issued to the noteholder;
  • how the company’s cap table will change following the conversion; and 
  • what steps the company needs to take to effect the conversion.

If you have questions about convertible notes, or require assistance in drafting or converting a convertible note, contact LegalVision’s capital raising lawyers on 1300 544 755 or fill out the form on this page.

About LegalVision: LegalVision is a tech-driven, full-service commercial law firm that uses technology to deliver a faster, better quality and more cost-effective client experience.

The majority of our clients are LVConnect members. By becoming a member, you can stay ahead of legal issues while staying on top of costs. For just $199 per month, membership unlocks unlimited lawyer consultations, faster turnaround times, free legal templates and members-only discounts.

Learn more about LVConnect

Sophie Mao
Get a Free Quote Now

If you would like to receive a free fixed-fee quote or get in touch with our team, fill out the form below.

  • We will be in touch shortly with a quote. By submitting this form, you agree to receive emails from LegalVision and can unsubscribe at any time. See our full Privacy Policy.
  • This field is for validation purposes and should be left unchanged.
Our Awards
  • 2019 Top 25 Startups - LinkedIn 2019 Top 25 Startups - LinkedIn
  • 2019 NewLaw Firm of the Year - Australian Law Awards 2019 NewLaw Firm of the Year - Australian Law Awards
  • 2020 Fastest Growing Law Firm - Financial Times APAC 500 2020 Fastest Growing Law Firm - Financial Times APAC 500
  • 2020 AFR Fast 100 List - Australian Financial Review 2020 AFR Fast 100 List - Australian Financial Review
  • 2020 Law Firm of the Year Finalist - Australasian Law Awards 2020 Law Firm of the Year Finalist - Australasian Law Awards
  • Most Innovative Law Firm - 2019 Australasian Lawyer 2019 Most Innovative Firm - Australasian Lawyer
Privacy Policy Snapshot

We collect and store information about you. Let us explain why we do this.

What information do you collect?

We collect a range of data about you, including your contact details, legal issues and data on how you use our website.

How do you collect information?

We collect information over the phone, by email and through our website.

What do you do with this information?

We store and use your information to deliver you better legal services. This mostly involves communicating with you, marketing to you and occasionally sharing your information with our partners.

How do I contact you?

You can always see what data you’ve stored with us.

Questions, comments or complaints? Reach out on 1300 544 755 or email us at info@legalvision.com.au

View Privacy Policy