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The Basics of Convertible Notes (and the Rich Friends that Make Them Work)

rich-guySo you have a great idea for a startup but you have one small problem: you have no money. Your best friend (pun intended) at this stage is the convertible note. A convertible note is basically an unsecured loan, meaning if you are unable to repay it, you aren’t personally on the hook. This is one of the major reasons it’s important for startups to hire a lawyer, to make sure that your company is properly structured and limit your personal liability in these situations.

Convertible notes are becoming more and more common in today’s startup world for a couple of reasons. They are designed to keep legal involvement and costs to a minimum. Convertible note term sheets are usually two to three pages long, as opposed to eight to ten pages for typical preferred stock financing. Deals typically can be completed within a few hours, and often without legal counsel (although it’s usually still wise to hire a lawyer).

So, you’ve got a great idea and no money of your own, but lo and behold, you’ve
found yourself a rich friend willing to loan you a $100,000. Do you have any collateral
to secure the loan? No? Don’t give up now, this is where the convertible note comes into play. Like any loan, this document includes the term, interest rate, repayment
terms, maturity date, and so on.

But, unlike a typical loan, you don’t even need to pay off any of the interest or
principal until the maturity date, usually 12 to 24 months. Better yet, your rich friend
doesn’t expect to be repaid if it fails completely. Your rich friend should know that he/she is gambling on your idea and your ability to make it a success – there is no security for the loan, and no guarantee that it will be repaid.

Let’s jump forward 12 months. Now the maturity date is coming up and you’ve managed to turn your great idea into a living, breathing startup. Things are getting exciting and you’ve managed to get your first few paying customers. But, you want to know what to do about that whole loan thing. Upon maturity, the convertible note becomes due and payable in full, including accrued interest. At this point, paying back $100K plus interest is probably a task your startup can’t afford.

Don’t worry. This is why convertible notes are a beautiful thing – flexibility. Your rich friend probably saw this coming, and there are some simple ways of solving the problem. You can negotiate an extension of the maturity date, convert the note into shares of common stock at the company or noteholder’s option, or if your idea has really caught on and you have enough cashflow, you can pay back the loan plus interest.

Now if your idea wasn’t all that great, or you lost that $100K from your rich friend and have nothing to show for it, again, don’t worry. Remember, loans of this nature are generally unsecured and not guaranteed by founders and shareholders, so you’re technically off the hook. The company may have gone under, and your investor gambled and lost, but in the end you gave your idea your best shot and didn’t lose a thing… well, except for probably that rich friend’s friendship.