How to Convert Promissory Notes to Equity

Promissory notes are a form of debt that will pay you interest and return the principal to you at maturity. However, it can be in your best interest at some point to ask the note-issuing company to covert it to equity. They might be happy to do this -- particularly if they're having a tough time financially. Keep in mind that promissory notes are generally issued to investors like you, and not to lenders or creditors, so converting your note to equity (in other words, partial ownership of the company) is often a possibility.

Conversion Option

Some promissory notes are convertible at issuance; others may be converted to equity at a future date for a discount price as specified in the promissory note's prospectus. As a holder of convertible promissory notes, you are guaranteed to share in a company's success if its business becomes profitable. Your company must promise the return of the investment principal if you decide not to exercise the conversion option, which would mean that your promissory note would remain just that -- a promissory note, which is just a loan.

Court-Arranged Conversion

If your note issuer goes through a debt restructuring -- in other words, some form of bankruptcy -- it may be necessary to pursue your equity conversion under court arrangements. This may include lowering your interest rate, reducing your borrowing principal, or extending your maturity date. In some cases, equity conversion may be the only choice approved by the court if a company is unable to accept payment arrangements. At that point, your best hope for repayment is that the company can reverse its fortunes and produce future profits. You're betting that it is a better alternative than losing your investments altogether if the company is forced to liquidate because too few of its note holders will accept equity instead of loan payments.

Voluntary Conversion

Promissory notes as debt are less risky compared with direct equity investments. Thus, companies incur lower financing costs using promissory notes than they might by offering equity interests. However, companies are obligated to make regular interest payments on promissory notes, which can be a burden if the business goes through a period of low cash flow. If growth is expected for the future, the company and you may come together and agree to a conversion. It can relieve the company from current debt liability, and you can earn higher equity returns in the future.

Note Reassignment

You will run into situations when a company will not want to make this conversion. If its business is doing well, and it can afford to meet debt-payment requirements, it has no motivation to make the change. In that case, you'll need to reassign and sell your promissory notes to other investors and invest the proceeds directly in the company's equity if you want to own a piece of it. This is fine unless such actions are specifically prohibited in the note offering. Equity investments in a potentially profitable business can give you a higher return, but switching investments to equity can also be risky if you misjudge a company's future growth potential. As always, your investments will succeed or fail based on your ability to read the tea leaves and predict the future.

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About the Author

An investment and research professional, Jay Way started writing financial articles for Web content providers in 2007. He has written for, and Way holds a Master of Business Administration in finance from Central Michigan University and a Master of Accountancy from Golden Gate University in San Francisco.