What Is a Convertible Promissory Note?

New business ventures often have difficulty obtaining capital, whether for starting up or for expanding operations. This is especially true during economic downturns where commercial lending underwriting standards are tightened. At the same time, a number of investors often seek non-traditional investment opportunities to enhance their portfolios. A convertible promissory note is a debt instrument that converts to equity in the company that issues it when certain conditions outlined in the promissory note are met. The conversion from debt to equity may be voluntary or mandatory depending upon the agreement between the issuer of the note and the investor.

A convertible promissory note provides an opportunity to serve the needs of both the business needing capital and the investor seeking an opportunity. The following example can help illustrate this.

Martin is the owner of a small technology firm that has just developed a new robotic system for use in the manufacture of hydrogen fuel cells. While his patent is pending approval, he seeks traditional bank financing for plant and equipment necessary to start production but is turned down given the risk involved in the emerging green energy market. After consulting with his accountant and lawyer, he decides to seek investors in his company by offering convertible promissory notes. He is able to obtain enough capital from the notes to start production. Eventually, the notes become convertible and several of Martin's investors decide to convert their notes to equity in the company pursuant to the terms of the convertible note. Martin is no longer the sole owner of the technology firm.

A convertible promissory note has two primary elements: the promissory note and the equity conversion rights. A typical promissory note will include the principal, interest rate, maturity date, whether the note will be secured by assets of the company and default provisions with related remedies.

The equity conversion side of the transaction will include a definition of the event that triggers the conversion, the formula used in converting the debt to equity, the type of equity to which the debt will be converted (common stock versus preferred stock, for example), and any additional equity rights attached to the shares converted from the debt such as voting rights and dividend rights. The lender may impose further requirements such as the right to approve the company's budget.

A business owner contemplating using a convertible note as an alternative means of financing a startup or business expansion needs to understand that the investors have the right to convert the debt to equity which is an ownership interest in the company. Business owners need to weigh the advantages of obtaining financing against the reality of new owners who will share in the management, control and profits of the business.

Convertible promissory notes will almost always be considered a security under federal and state securities laws and regulations. It will be necessary for a business contemplating utilizing convertible notes to raise capital to consult with an attorney who specializes in securities law.