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Legal Matters: Convertible Note Gotcha’s

I’ve never invested with Convertible Notes before, the idea has always had a funny smell that’s put me off. I feel too inexperienced with Convertible Notes, and therefore don’t feel like I know all the risks and things to look out for when buying Convertible Notes.

What Are Convertible Notes?

Convertible Notes are an alternative to buying shares, in order to invest in a company. Essentially Convertible Notes are a legal contract that defines a thing you get, which at some point should convert into actual shares in the company.

Convertible Notes are a great way to invest if it’s hard to place a value on the company. For example, if a company has limited financial history making a valuation difficult, then Convertible Notes can be used to invest, such that the notes convert into shares after a period of time has passed that would enable a valuation. The value that they would convert into would then be based on that future value and an investor would either get a large chunk of a small company, or a small chunk of a big company.

Problems With Convertible Notes (From An Investors Perspective)

Like any legal contract, you have to read and understand the terms so you don’t get caught out. You also need experience in the area to know what gotcha’s need covered off, and what snakes could be hiding in the long grass.

As I am inexperienced when it comes to investing in companies via Convertible Notes, I thought it might be useful to use this article to store information about Convertible Note gotcha’s that I come across or can think of. I expect this list to grow organically as I discover new information or am forced to investigate this more thoroughly due to investment opportunities popping up with Convertible Notes. If you are aware of things that should be added to the list, please leave a comment below.

  • Convertible Notes must have a condition that ensures that they convert into shares, and it must be impossible for that condition not to not come true, otherwise the Convertible Notes will never be worth anything.
    An example of a Convertible Note that never matures would be one that is converted to shares based on the market value ascribed at the next capital raising. Existing shareholders / directors could then ensure that they never raise any more capital, causing the Convertible Notes never to convert to shares.
  • You don’t have the same rights as a shareholder, which means the terms of your investment could change if the existing shareholders vote to change the Company Constitution.
  • In the case of investing in very early stage companies, the (typically 20%) discount to the next capital raise that you get in buying the Convertible Notes is probably not enough to represent the level of risk of investing in a less mature company – so the risk premium is not fairly reflected in the price of the Convertible Notes.
  • What happens if the company is bought out? Is this covered by the conditions of the note?
  • What happens if the subsequent fund raise which dictates the value of your Convertible Notes is not at arms length from the existing shareholders? They could manipulate the share price higher, so you don’t get fair value for your investment.

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