The Basics of Convertible Note Agreements: A Beginner’s Guide

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Navigating startup finance can feel like solving a complex puzzle. With countless financing options, it’s easy to get lost. Imagine 16% of startups fail due to financial problems. But there’s one tool every founder should know: the convertible note. It can significantly impact your startup’s journey.

Now you might wonder, “Why should I learn how to create convertible note agreements?” This straightforward mechanism offers a cost-effective way to secure capital and future equity.

This guide to convertible notes provides strategies for writing a legally binding and fair agreement. Read on to understand the basics.

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Guide On How To Write A Convertible Note Agreement

Convertible note agreement creation is a bit like baking a cake. It might seem a bit tricky at first, but with the right ingredients and careful steps, you can whip up something pretty impressive.

1. You are starting with the basics – the main amount your startup is borrowing and the interest that adds up over time. Think of these as your flour and sugar.

2. Next up, add some eggs and butter – The nitty-gritty of how the loan morphs into equity. Spell out the ‘when’ and the ‘how,’ including the price at which the debt will turn into shares in your startup.

3. And like any good recipe, it’s always wise to have a backup plan, like what happens if your startup is sold before the loan gets a chance to convert.

Don’t forget the possible scenarios where your startup might want to repay the loan before it’s due or turns into equity. It’s like deciding whether to ice your cake before it’s completely cool – sometimes it’s allowed, and other times there might be penalties.

Remember, while you might know your way around baked goods, drafting convertible note agreements is a different ball game.

When in doubt, it’s always wise to call a professional, a legal counsel – to ensure everything is shipshape and in line with all the relevant rules and regulations.

Download the Convertible Note Agreement Form

Below is a preview of Convertible Note Agreement Form. Use this form for free when you sign up for a Fill account.

convertible note agreement

Essential Elements of Convertible Note Agreement

Writing convertible note agreements can feel like a mountainous task. But with the right understanding and careful attention to detail, you can craft one that is balanced and beneficial for both parties.

Here’s a closer look at the key components to include:

Principal and interest

At the core of your draft is pinpointing the principal amount – the money being borrowed initially.

Ensure to spell out this figure in the agreement. Now, alongside the principal, you’ll need to lay out the interest rate, essentially the fee for borrowing the money. This interest builds up over time, increasing the total sum that could be turned into company shares.

Conversion

The next crucial component is the conversion terms. This includes scenarios for the following:

  • Mandatory conversion – It refers to when the note must convert into equity. Two common scenarios for mandatory conversion are at the maturity date (when the note is due) or during a qualified financing event (when the company raises a certain amount of capital).
  • Conversion price – This is the price at which the debt will convert into equity. It’s usually based on a discount to the price per share in the next financing round or a valuation cap.
  • Change of control: This provision outlines what happens if the company is sold before the note converts. Noteholders may be entitled to convert the note into equity immediately or receive a payout.
  • Automatic conversion – This term states that conversion from a note to equity will happen automatically during specific events, such as a new funding round.

Pre-payment terms

The pre-payment terms outline whether and how the company can repay the loan before it’s due or before it converts. Some notes have a no pre-payment clause, while others may allow for pre-payment with specific penalties.

Documents

Several key documents accompany a convertible note agreement:

  • Note purchasing agreement that outlines the purchase of the convertible note, including the purchase terms.
  • Convertible note agreement, the primary agreement that outlines the terms of the loan and its conversion to equity.
  • An investor questionnaire is used to verify that the investor is qualified and understands the risk associated with the investment.

Note purchase agreement

The note purchase agreement is a critical document, which contains the specific terms under which the convertible notes are issued and sold to investors. It should include information about the sale, like the number of notes being sold, the price per note, and the closing date of the sale.

Legal and other expenses

Finally, your convertible note agreement should cover who is responsible for legal and other expenses related to the agreement. Typically, the company shouldered these costs, but the specifics can vary based on negotiation.

It’s crucial to consult legal counsel when drafting a convertible note agreement. This ensures all legal compliance requirements are met and bases are effectively covered.

Recommended Strategies When Writing A Convertible Note Agreement

When writing a convertible note agreement, think of it like planning a road trip. You want to reach your destination but also need a solid plan and a well-packed bag.

  • Firstly, clarity is key. Make sure every part of the agreement is clear and understandable, like a well-written roadmap. Avoid legal jargon when you can, and when you can’t, explain it.
  • Secondly, don’t rush the journey. Take the time to discuss and negotiate the terms. This might be a longer process, but it ensures everyone is on the same page and happy with the conditions.
  • Finally, it’s okay to ask for directions. Don’t hesitate to involve a solid, ready-made template like Fill offers. They can help you navigate any tricky terrain and ensure your agreement is reliable and compliant with all the necessary rules and regulations.

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How Fill Can Help Write A Convertible Note Agreement

Wrapping your head around how to write convertible note agreements can seem like learning a new language.

You’ve got to grapple with terms like ‘principal’, ‘interest’, and ‘conversion’, and that’s before you even get to the legal intricacies. But here’s the good news: you don’t have to do it alone. Fill is here to be your co-pilot.

Our platform is built to make drafting legal documents simpler and more efficient. Think of Fill as your guide, helping you navigate the challenging terrain of convertible notes. We have various tools and templates, each designed to make your task easier and your results more professional.

Ready to see how Fill can help you write a convertible note agreement? Get started today and experience the ease of drafting legally binding contracts.

Krisette Lim

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