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Convertible Promissory Notes – What They Are and How They Work

What is a convertible promissory note?

A convertible note is a debt instrument, similar to a bond that may be convertible into equity (common stock) at a future date. The conversion may happen upon the occurrence of certain events or at the choice of the investor. The conversion feature is the mechanism by which the debt (the note) will convert to equity (new shares for the investor) upon a future event.

Most convertible notes are issued by smaller, less established or speculative corporations to raise money for investment and business operations.

What are the common elements of a convertible note?

There are two primary elements:

  1. The note. A typical note will state the principal, interest rate, maturity date, whether the note will be secured by assets, default provisions, and the related remedies.
  1. The equity conversion rights. The equity conversion aspect will state a definition of the event that triggers the right to 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), and any additional equity rights attached to the shares converted from the debt, such as voting rights and dividend rights.

Convertible notes are hybrids securities that offer some protections due bondholders– shelter from liability and senior status if insolvency occurs, with a predictable income–and the potential for upside gain if the equity does well.

Why are convertible notes issued?

New business ventures and small operating businesses often have difficulty obtaining capital (whether for starting up, or for expanding operations). During economic downturns this is especially true because loan underwriting standards are tightened. But, at the same time, a number of investors often seek non-traditional investment opportunities to enhance their portfolios. A convertible promissory note provides an opportunity to serve the needs of both the business…

Read More…. by Lawrence Tepper

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The post Convertible Promissory Notes – What They Are and How They Work appeared first on Note Investing Seminars.

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