Convertible Notes For SMEs
Access to finance has always been a primary challenge for Small Medium Enterprises (SMEs) and affects their growth prospects. Fortunately, there are several financial opportunities available to SMEs.
Access to finance has always been a primary challenge for Small Medium Enterprises (SMEs) and affects their growth prospects. Fortunately, there are several financial opportunities available to SMEs. In this article, we provide an overview of convertible notes, their advantages as well as the most common terms you should include in a convertible note.
What is a Convertible Note?
A convertible note (also known as convertible debt) is a short term debt that converts into equity in the issuing company. In other words, investors loan money to the SME and instead of receiving the money back together with interest in future, the investor receives shares in the company, based on the terms of the note.
What are the advantages of a Convertible Note to the SME?
1. Speed, Simplicity and costs– Convertible notes are simpler to draft, document and enforce hence reduced legal costs for the SME.
2. No strict requirement for valuation to access financing – this is especially advantageous to SMEs which have not had enough operating history to ascribe a positive valuation.
3. Fast and straightforward way for SMEs to raise money.
4. Convertible notes allow startups to focus on growing their business before they have to start paying back debt.
5. Convertible notes do not require ceding any portion of a company control to the investor at the time that the money is given. This effectively buys the company more time, perhaps a few more years, to develop without having the investor in the boardroom.
6. Investors have a chance to acquire stake in the company.
Essential terms to include in the convertible note.
1. Interest – the invested funds accrue an interest at the rate prescribed in the note. The interest rate amount is added to the principal amount when the note is converted. Interest rates are usually low and in line with current rates as the value is primarily in the equity conversion.
2. Maturity date – this is the date at which the notes are due and payable to the investor if they have not already converter to equity. The clause may also stipulate whether or not the notes shall have an automatic conversion at the maturity date.
3. Conversion discount – In addition to the investor receiving the value of the principal amount plus interest, the investor may also benefit from a conversion discount. A conversion discount refers to the negotiation of a lower share price when a convertible note is converted to stock. Convertible note debt typically converts into equity in the next preferred round of financing. With a conversion discount, more stock is being bought with less cash.
For example, if the discount is 20% and the new equity in the qualified financing is sold at $2.00 per share, the convertible note’s principal plus accrued interest converts at a share price of $1.60 per share.
How can we assist you?
At CM SME Club, we have an experienced team of lawyers who can offer you legal assistance in drafting and enforcing convertible notes to your best interest. Please contact us for our services via email or call +254 745 342 125. Visit our website for more information on our services.
Published on Aug. 22, 2024, 1:10 p.m.