A promissory note conversion agreement, also referred to as convertible promissory note, is a debt agreement that converts to equity after a specific date or event. The conversion of the note from debt to equity will depend on the terms and conditions between the company and the investor.
The agreement will have the principal amount, interest rate, maturity date, security used to secure the note, and the details of what will happen should the company get into default. In addition, the agreement will also contain details of conversion, the event triggering the conversion, type of equity the investor will get on conversion, and the rights of the investors once the conversion takes place.
Purpose of Promissory Note Conversion Agreement
The main purpose of the promissory note conversion agreement is to convert outstanding debt into equity at the behest of the investor, who is the promissory note holder. Usually, a company opts for this agreement when it is trying to raise capital without having to get its books audited.
When Do You Need A Promissory Note Conversion Agreement?
As stated earlier, a promissory note conversion agreement helps a company raise capital for its business. The organisation does not have to put value on their business when they opt for this agreement. It is an apt method for start-ups to get funding. It is the easiest and quickest way for investors to invest in an organisation without entering the stock market. The agreement lists out the deal and they can get the preferred stock of the company without any hassle.
Inclusions in Promissory Note Conversion Agreement
Along with the standard boilerplate clauses, a promissory note conversion agreement has the following inclusions:
- Names and addresses of the investor and company
- The principal amount and the interest rate
- The date on which company will pay the interest and principal if the hotel does not convert the promissory note into equity
- The exact details when the conversion can take place
- The process of conversion
- Information what the investor can do with the equity
- Any other issue that the parties want to address, including the jurisdiction of any dispute that arises or there is breach of the agreement
How to Draft Promissory Note Conversion Agreement
When drafting an agreement, some of the following details should be included:
- Promissory note convertible to equity agreement should mention the kind of shares that the investor can convert the promissory note into
- The rights of the investor before and after conversion
- What happens if the company does not get additional funding and the maturity date of the agreement is reached?
- Detailed outline of the conversion and when it will take effect
- The price of the conversion, which is pre-determined, but it is often negotiable. Hence, should be clearly mentioned in the agreement
- As required by the securities law, what the investor can do with their equity.
Pros and Cons of Promissory Note Conversion Agreement
Some of the advantages of the agreement are:
- Quick way for the company to get funding
- Easy way to invest in a company without entering the stock market
- Promissory note convertible to equity is cheaper for the investor compared to buying shares
- Investor can negotiate the price of the conversion to benefit in a bull or bear market
- Can offer high returns in the form of interest
On the other hand, the agreement also has some disadvantages:
- It can be risky investment if investing in a start-up
- Initial investors may not be well-compensated for the investment they do
- If the company goes bankrupt before maturity of the promissory note, the investors can lose their investment entirety
- If the company decreases in value, the investor could end up owning more equity than anticipated
Types of Promissory Note Conversion Agreement
Promissory note conversion agreement has two parts to it. They are:
- Promissory note, where it has the principal amount, interest rate, maturity date, how the note is secured and what happens if the company defaults
- In equity conversion, it will detail the event that triggers the conversion, the formula used to convert debt to equity, the type of equity that the investor would get and the rights that the investor enjoys on conversion to equity
Key Terms / Clauses in Promissory Note Conversion Agreement
Some of the key terms in the agreement include the following:
- Number of Shares: The number of shares that the investor will get when converting the promissory note to equity
- Maturity Date: The date when the promissory note conversion agreement matures and can be converted to equity or the investor can ask for repayment of principal amount and interest
- Conversion Rate: The rate at which the promissory note is converted into equity
- Representation and Warranties of Lender: It is mandated by the securities law and explains what the investor is allowed to do with their equity
What Happens When You Violate Promissory Note Conversion Agreement?
If you violate the promissory note conversion agreement, you may not be able to convert the debt into equity, resulting in loss of investment. In case the company breaches the agreement, you can use the contractual remedies detailed in the agreement or opt for legal action against the company.
[Also Read: Promissory Note with Collateral Agreement]
Sample of Promissory Note Conversion Agreement Sample
A sample of the agreement can be downloaded from below.
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