Brief introduction:
To better understand the advantages and disadvantages, we will need to first understand what convertible notes really are and then we can better appreciate their usage. We have a previous article posted here: What is a convertible note?. This article spells out the usual steps a company may take to issue a convertible note. In this article, however, we will focus on understanding when convertible notes are typically used and their advantages and disadvantages.
To start off, convertible notes are a form of debt. To put it this is a form of borrowing. The company issues convertible notes to creditors and in exchange, the creditor is repaid with equity in the company rather than principle and interest. The creditors are typically referred to as investors rather than creditors. As a point of reference, a company can raise capital either through financing or issuing equity.
Why do companies choose to use convertible notes rather than issue equity?
Convertible notes allow the existing shareholders to retain control of the company. Think of the holders of convertible notes as typical creditors. If a company borrows money from a bank, the bank does not get to vote at a general meeting of the company as the bank is not a shareholder of the company. In the same vein, the company can retain its current share structure rather than cede some form of control to new incoming shareholders. Hence this is an advantage for the company and a disadvantage for the holders of convertible notes. As a person who is “lending” money to the company. I would prefer to have some control over the day to day running of the company. If I were a shareholder, I could perhaps influence the company through my votes on company matters in shareholder meetings.
Then why would the investor give in to obtaining convertible notes rather than equity?
The investor would have the advantage of investing in a start-up that is not ready for valuation. Usually, this would give the investor a large opportunity of an upside as compared if he were to place his money in an already established company. At an early stage, valuation is usually difficult. Hence convertible notes allow the company to defer valuation of the company until later. i.e. subsequent rounds of financing. The advantage would be that since there is no valuation and the risk is high because it is a start-up. To make it worthwhile for the investor, the company will have to give them favourable terms for the convertible notes. This is typically in the form of a discount rate. i.e. this allows the investors to convert their principal loan amount and interest into equity at a certain reduced price relative to the investors in the subsequent rounds, be it later issued convertible notes or equity. If the investor thinks that the start-up is heading somewhere, the convertible note will allow the investor to enter the market for the company’s shares at an extremely favourable rate.
So what are the downside risks?
A huge one would be the lack of investor control. At the stage of holding the convertible note, the investor is not a shareholder. He has no control over the management as he has no votes. If subsequent rounds of funding are not favourable to him, he cannot use his vote as a shareholder to sound his protest for the plain fact that he is not a shareholder. He is not a shareholder until the convertible notes are converted into equity, i.e. shares.
Weighing the decision to issue debt in the form of convertible notes as a company can be an important decision. The company will have to decide whether it would like to cede some form of future equity in the form of convertible notes or would it be better to simply obtain financing from a bank. That being said, the bank would typically categorise such start-ups as risky and this line of credit may not be on the table at all for the company. As a creditor, the risk-benefit analysis has to be one where the risk of the start-up not taking off is weighed against the benefit of the potential to reap large returns from the investment.
If you are a company that is looking to issue convertible notes, you can engage our company to assist in the process. To do so, you can contact us at this email: [email protected].
When in doubt, seek legal advice or consult an experienced ACRA Filing Agent.
Yours Sincerely,
The editorial team at Singapore Secretary Services
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