What is a Convertible Note ?.

When I talk with businesses the topic of funding is usually the first-cab-off-the-rank.

One of the most effective ways to raise the funds in the post-GFC world is through Convertible Notes.  When I talk about this, the first reaction from most people is “what is a Convertible Note ?”.

So, to stop that little record being played over and over, I now point people to this Blog entry.

Feel free to contact me if this is a topic of interest to you for your business, or you just want to know more about the topic.

A convertible note (or, if it has a maturity of greater than 10 years, a convertible debenture) is a type of bond that the holder (Investor/Bank) can convert into:

  • Shares in the Company they’ve put the money into, at an agreed value (per share); or
  • Cash, of equal value to the money they’ve put into the Company.

Either way, the Investor will receive interest payments on the way through at an agreed-upon annual interest rate and at agreed-upon frequencies.

In terms of exercising a choice (Shares, or give me my Cash back), this is the Investor’s choice and the Company must accept that choice whether it is convenient and whether they like it or not.

The types of frequencies I most often see are:

  • Quarterly in arrears;
  • Half-yearly in arrears;
  • 50:50 (50% up-front, and 50% at the agreed end-date);

Each type of frequency has a different risk profile for both the Investor and the Company, and therefore the rate of Interest is expected to be quite different because of the risk spectrum.

A convertible note is a hybrid security with both debt and equity features.

The Investor receives the potential upside of conversion into equity, at an agreed price today for some point in the future, while protecting their downside with cash-flow from the “convertible note” payments.

From the Company’s perspective, the key benefit of raising money by selling convertible notes is (hopefully) a faster approval timeframe than a bank can achieve plus a deferral of dilution of all the other shareholders (though it will be inevitable if the Company does very well).

In the present Australian market, private convertible note arrangements vary from a duration of 6 months to 5 years and vary from an interest rate of 10% to over 20%.  The massive difference in interest rates relates to the frequency of interest payments and the risk-levels that the Investor perceives the Company as being for them to get their entire capital back.

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