Convertible Note

An investor invests $10,000 in your business and they get a Convertible Note, which says that if the business raises $1,000,000 in the future, the Convertible Note converts into equity and the investor gets shares in the company. The $1,000,000 funding round amount is called a “qualified funding round”. The $10,000 investment converts into shares at a 20% discount from the share price reached in the future $1,000,000 round.

If the larger future round raises $1,000,000 at $100 per share, the Convertible Note investor gets their shares for 20% off at just $80 per share. That means:

Other Investors: Without the discount, the other investors will only get 100 shares ($10,000 ÷ $100 = 100 shares).

Convertible Note Investor: With the discount, the Convertible Note investor’s $10,000 gets them 125 shares ($10,000 ÷ $80 = 125 shares). This larger number of shares allows the investor to keep a bigger equity position in the company or to sell their shares to other investors for the higher $100 price and pocket a 20% return on investment.

As a note, the qualified funding round amount ($1,000,000 in our example) is negotiated between the business and the investor.

A Convertible Note and a Simple Agreement for Future Equity (SAFE) are very similar, but they are not the same thing. The main difference is that a Convertible Note is a debt owed by the business to the investor. So, it must be either repaid or be converted into equity. Convertible Notes also collect interest.

In contrast, a SAFE is not a debt and usually does not have to be repaid. A SAFE investor’s only way of making a return on the investment is through it being converted into equity in the future.

A Simple Agreement for Future Equity (SAFE) is generally considered to be a more friendly type of investment for the business. A SAFE is not a debt, so it usually does not have to be repaid. SAFEs also usually don’t carry interest. Both of these features are better for the business.

In contrast, a Convertible Note is a debt that must be repaid if it does not convert to equity in a future funding round. Convertible Notes also almost always charge interest. These features are better for the investor.

SAFEs are becoming the more common type of investment, even though a Convertible Note has some advantages for investors.

To strike a balance when using a SAFE, sometimes investors will ask that a SAFE include a priority repayment clause, which means that if the business is dissolved or goes into bankruptcy the SAFE gets repaid before the shareholders get any return of their investment (e.g., the SAFE investors get repaid first before the founders take any of the money or assets left over when the business is wound up).

Again to strike a balance compared to a Convertible Note, some investors will also require the SAFE to charge something that looks a lot like interest, but it only gets applied when the SAFE converts into equity. For example, the SAFE might say that the investment gets an additional 6% bonus on conversion. If the SAFE amount was $100,000 and a year later it converts into equity when the business does a larger qualified investment round that triggers conversion, the investor gets an additional $6,000 (6% of $100,000) that will be converted into equity.

A Convertible Note is different from a Subscription Agreement.

A Convertible Note is a loan that says the investor gives the business money today and in the future when the business successfully completes a larger financing round, the investor may convert the loan into shares at that time. The benefit? The investor gets their shares at a discount to the future funding round’s price per share. It’s a way of rewarding early investors for the risk they took on the business.

With a Subscription Agreement, the investor gets their shares today at a price the business and investor agree to today. So, there is no future element of the deal. The investor becomes a shareholder and owner of the business as soon as they make their investment.

No, a Convertible Note is not used to give someone stock options. For that, we use an Option Agreement and if the options are granted to employees, independent contractors, or consultants, we also usually also have a Stock Option Plan (sometimes called an Equity Incentive Plan).

Yes, a Convertible Note can be used for shares in a corporation.

Yes, a Convertible Note can be used for units in a partnership.

Equity means shares in a corporation or units in a partnership.

The basics

When someone invests in a corporation to become an owner of it, they get shares that represent their ownership in the business. Shares are a “share of” the ownership of a business. So if you’re the only owner of your business, you could have 100 shares or 100% of the ownership. If you have two owners, each could have 50 shares or 50% each of the business.

Some more details

Shares come in classes. There are two broad categories of shares: Common Shares and Preferred Shares. Common Shares are, well, the regular type (as the name suggests).

Preferred Shares are called “preferred” because they can have special rights attached to them. The primary benefit that makes these shares “preferred” is that they rank ahead of the Common Shares when the business is dissolved or winds down. That means that if the business is dissolved and there is enough money left after the company’s creditors (like banks and other lenders) are paid, the Preferred Shares get their investment back. Only after the Preferred Shares get their investment back will the Common Shares get anything that’s left over.

Shares can be voting or non-voting and you can also set them up in individual classes, like Class A Voting Common Shares and Class B Non-voting Common Shares.

Even more complexity, if you want it…

To add to the complexity, you can have sub-classes within shares called “Series”. For example, Class A Voting Common Shares, Series 1, or Preferred Shares, Series 1, Series 2, etc.

If you’re getting overwhelmed, don’t worry. You don’t need to get fancy with classes and series unless you have tax planning or professional investors involved. A typical share set up could look like this:

• Class A Voting Shares – used for founders and major investors
• Class B Voting Shares – used for minority investors that you want to have a say in some business decisions
• Class C Non-voting Shares – used for minority investors or people you pay with shares but should not be able to vote on business decisions
• Preferred Shares – if you’re a small business, you likely will only use Preferred Shares if your accountant suggests it as part of a tax planning strategy

There is a lot of flexibility when you structure a business. The important thing is to set up your shares in a way that works for you. If you’re in doubt, you can talk to a lawyer through the Made It Legal Marketplace to get some extra help.

Units in a partnership are very similar to shares. Units represent part ownership of the partnership. So if someone owns 50 units in the partnership out of a total of 100 units held by all the partners, that person owns 50% of the partnership.

Partnership units can be set up in different classes, much in the same way as shares. So, they can have different voting rights and other benefits.

A private placement is what we call a sale of shares (or units in a partnership) to a pre-selected set of investors rather than to the public through a stock exchange. So, it’s a private sale of an investment to a group of investors, usually friends and family, angel investors, or professional investors (venture capitalists, private equity firms, or “accredited investors”).

An Angel Investor is usually a wealthy individual that is a knowledgeable investor in your industry. They seek out attractive investment opportunities but usually don’t want to take too active of a role in the company.

There actually isn’t anything legally different about an Angel Investor compared to a Venture Capitalist, Private Equity Firm, or Accredited Investor. The difference usually comes down to motivation and how much oversight and involvement in the business the investors wants to have.

An Accredited Investor is an individual that meets certain knowledge and wealth requirements under investment laws. If the person is a professional investor with enough income and net worth, they are exempt from some of the more complicated investor disclosure rules that businesses must follow when taking investment money. So, it’s easier for a business to take the investment.

Private Equity Firms are much the same as an Accredited Investor, but are usually a group of Accredited Investors working together as a firm or an investment business.

A Venture Capitalist (also called a “VC”) is another word for a professional investor. They are usually Accredited Investors and their business is investing in private companies, often start-ups, and they usually have a plan to sell their investment in the future (called “exiting a position”). They often want a high degree of oversight in the business through regular reporting or being on the Board of Directors. Although there is a reputation out there about VCs being sharks, the right VC investors can be great partners in your business since they bring a lot of knowledge and connections with them along with the dollars they can put into your company.

Yes, friends and family can invest in your business. Actually, friends and family is a category of investor that is exempted from some complicated investor disclosure laws. So, getting investment from your close friends, business associates, and family can be a great way to boost your company with the dollars it needs to grow.