The use of convertible notes has become an increasingly popular mode of financing corporate debt. For startups it can be a flexible and useful means of raising funds from a group of investors without the need to incur the cost and administrative burden of an institutional trustee and all that entails.
Convertible notes: how do they work?
Convertible notes can be either unsecured or secured. Where they are unsecured, the process and documentation which applies to larger market transactions can be easily adapted to suit.
Where the notes are to be secured however, a question will arise as to the most appropriate way to create, hold and manage the security. This can be dealt with in a number of ways, depending largely on the number and nature of the proposed note holders/investors.
In a typical transaction, the security to be granted by the note issuer (which is generally over all of its present and after-acquired assets) will be held by a trustee for the benefit of all note holders. That trustee may be an institutional trustee or a special purpose vehicle established by the issuer.
What do you need to consider?
The difficulties for a startup (which is generally looking to keep costs to a minimum) are the cost of engaging an institutional trustee and the administration issues which come with that engagement.
The potential investors may be reluctant to use a special purpose vehicle as a trustee given its necessary association with the issuer and the issuer’s promoters. Where there are relatively few note holders, all could become parties to a security document with appropriate pari passu provisions incorporated. The position becomes more problematic where the number of investors is greater (and may further increase over time) and it would be unwieldy to have all joined as signatories to a traditional security document.
One solution to this is for the issuer to grant the security interest by way of a deed poll – namely a security interest which is expressed to operate for the benefit of all note holders from time to time (as recorded in the note register). On becoming a registered note holder the investor would adopt the note terms and agree to the basis on which the security has been granted and will operate.
The note terms would provide that the rights of the note holders as “secured parties” rank equally with each other. They would contain provisions dealing with the exercise of rights under the security in the event of a default, by the incorporation of meeting procedures similar to those which apply to a shareholders meeting.
The note holders’ rights would include entitlements to vote at a meeting of all note holders and rules would be established to deal with the situation where some note holders may want to take enforcement action and others may not. In that situation, the note terms would include provisions where an agreed majority would prevail. This is similar to the approach used in a traditional multi-financier transaction.
There would also be provisions:
- authorising the notifications required by the Personal Property Securities Act, including the initial registration of the security interest and its discharge when the amounts owing under the notes have been satisfied (whether by payment or conversion);
- to enable the appointment by resolution of one or more note holders (holding a specified percentage of notes) to take any enforcement action on behalf of, and for the benefit of, all; and
- regulating the distribution of enforcement proceeds and the rights of the note holders amongst themselves, to ensure that each receives no more than its proportional entitlement.
As with all transactions of this nature, everything will turn on the expectations and requirements of those investors.