A Primer on Convertible Debt

Posted: Jan 25, 2013 12:01 AM

"I have a successful growing business, to the point where a number of investors are starting to knock on my door.

"My business is in a limited liability company (LLC), with two classes of membership interest -- voting and nonvoting. I did this on the advice of my lawyer and my accountant, who both suggested it was useful to distinguish between the founders of the company (they, of course, get voting interests) and investors (who get nonvoting interests).

"I have approached a number of investors (actually, they have approached me) and offered them nonvoting interests for a significant percentage of the company, but they are dragging their feet because they see my company as still too risky.

"I really don't want them to lend money to my company because I don't want long-term debt on my books, but I don't want to give up control of the company by giving them voting interests. I could just blow them off, of course, but truth be told I could really use at least some of the money they're throwing at me to expand my business.

"Is there any way I can make these investors happy and still keep control of my business?"

Yes -- you should consider offering them convertible debt.

A convertible note is basically an I.O.U. from a company to an investor. It operates the same way as any other debt instrument, except there's a provision in the note giving the holder (that's the investor) the right at any time to convert the note into a specified voting or nonvoting interest in your company.

By giving an investor a convertible note, you are enabling them to straddle the fence. If your company takes off and becomes wildly successful, the investor will convert the note into equity so she can grow along with you. If your company goes belly-up, the investor can hold onto the note so that, as a creditor, she will get their money out before others do.

Here are the terms you and your advisors will need to work out:

The Conversion Price: This is the ratio of the note's principal balance to the number of shares received upon conversion -- for example, "1 percent of the company's nonvoting membership interests for each $10,000 of the outstanding principal balance of the Note at the time of conversion." You should also consider whether investors will be allowed to convert their note in whole (all at once), or partially in several installments over time.

Timing: Most convertible notes give the investor the right to convert at any time, but you are free to add language saying the investor only gets the right to convert at a stated future time.

Forced Conversion: The investor always has the right to convert, but you may want the right to "force" the investor to convert earlier than she might wish. A future investor desiring to put a large sum of money into your company may insist that all holders of company debt be converted into equity. Without the right to force conversion, you would be forced to renegotiate each investor's note, and even a single no could force you to forego a big investment you may desperately need at that time.

What the Investor Gets Upon Conversion: With a corporation, this is simple -- the investor receives shares of the corporation's common or preferred stock. With an LLC, you have two choices.

You can specify that the investor will receive a percentage of the company upon conversion -- this means that any investor who comes on board before conversion will be diluted (their percentage ownership of the company will be reduced) when the conversion takes place; or

You can provide that the investor will receive a number of units of membership interest (similar to shares of stock in a corporation) upon conversion -- this means that the investor will be "diluted" by other people who make investments in your company before conversion takes place. You may have to amend your LLC Operating Agreement if it does not currently provide for units.

Other Documents: Because a convertible note is generally considered a security, you will need to prepare the following in addition to the convertible note itself:

--A subscription agreement by which investors agree to purchase their notes

--An investor questionnaire so your lawyer can determine if the investor is accredited for purposes of federal and state securities laws

--Your LLC Operating Agreement -- the investor does not sign this now (only upon conversion), but needs to review it now so she understands her rights and duties as an LLC member upon conversion.

It is important that the subscription agreement contain a clause requiring the investor to sign the LLC Operating Agreement she received as part of her investment package, "as the same may be amended or supplemented from time to time," when the note is converted. Otherwise you may not have the ability to change your company's Operating Agreement without her consent.

Cliff Ennico (crennico@gmail.com) is a syndicated columnist, author and former host of the PBS television series "Money Hunt." This column is no substitute for legal, tax or financial advice, which can be furnished only by a qualified professional licensed in your state. To find out more about Cliff Ennico and other Creators Syndicate writers and cartoonists, visit our Web page at www.creators.com.