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What is a Convertible Note?

What is a Convertible Note?

A convertible note can be a way for businesses to raise the money they need without enduring the delays of alternative routes. This article explains why.

14th June 2019
Reading Time: 3 minutes

One of the largest barriers to pursuing business endeavours is an insufficient amount of disposable capital. Not everyone can cash out a wealthy inheritance at a moment’s notice. Disposable capital is the engine of any business irrespective of whether that business is young or mature. Young businesses depend heavily on disposable capital to augment the efficiency of business processes and to fund audacious marketing strategies. Alternatively, mature businesses have generally reached an optimal level of efficiency and recognition. This means they cannot increase the value of their business by becoming more efficient. Instead, mature businesses require extra funding to make the necessary investments that will drive further growth and profitability. Businesses commonly use an instrument called a ‘convertible note’ to raise capital.

The Basic Idea

A convertible note is essentially a loan between the investor and the business. However, instead of using assets such as personal property for collateral, investors use their shares in the company. Hence, the investor provides the business cash to allow it to grow in exchange for an option to claim percentage ownership of the business in the future. In order to fully understand the convertible note, we need to familiarise ourselves with two things. Firstly, how investor ownership in a business is determined and secondly, the traditional methods of traditional ownership.

Percentage ownership can be calculated by dividing this number of stocks that the investor owns by the total amount of stocks that the business issues.

Example

Jessica has recently purchased 5000 stocks from JB-Hi Limited. The total amount of stocks that JB-HI Limited has issued is 200000. Therefore, Jessica owns 2.5% (5000/200000) of JB-Hi Fi Limited.

The traditional method of ownership transfer is through the exchange of stocks for a prescribed amount of money at the initial public offering.

How Can Businesses Benefit From a Convertible Note?

The biggest disadvantage of traditional share distribution is that both the business and the investor must agree on a valuation price before any transfer of ownership occurs. Determining a valuation price in the early stage of the business can come at the detriment of the business owner. This is because there is not enough information to predict how well the business will perform relative to its rivals. For example, business owners will suffer losses if they consent to valuation prices that are lower than their future value. This is especially so where your business is oriented to transform innovations into value and holds an impressive scale potential.

In contrast, the convertible note allows the transfer of ownership and hence, funding in the absence of a valuation price. As such, a convertible note delays the valuation conversation to a later point in time where the necessary information to make an informed decision is readily available. This means that businesses can start their business operations without delays and expensive legal fees.

In summary, a convertible note may be a desirable option for small businesses. This is because it allows the business to begin trading without inheriting the delays from established practices. This information cannot substitute the valuable insight that a Business Lawyer can bring to critical business decisions such as raising capital.

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Author
Eric Zhang

Eric currently works in the content team as a legal intern for Lawpath. He is in his final year of a Bachelor of Commerce with a Degree in Bachelor of Laws (Majoring in Finance).