What is a convertible promissory note?
A convertible promissory note is typically used in the early investment stage of a startup business. It is a loan which will, upon a predetermined event, convert from debt into stock.
How does a convertible promissory note work?
The process is best explained by an example:
- JT Smith likes your startup company and invests $100,000;
- Instead of issuing shares directly to JT Smith, you issue a Convertible Promissory Note;
- After six months of product development, you secure an additional round of investors for $1,000,000; (making your company’s stock more valuable)
- JT Smith, because he has a convertible debt instrument, will automatically convert his debt to stock;
- This conversion will likely be at a discounted purchase price (less than the current investors);
The value for the startup is a delay of stock valuation until the second round of investments. For the investor, the value is the ability to buy a young company’s stock at a discounted purchase price.
There are a variety of structure and tax considerations that must be addressed for this type of transaction. It is important to work with an Ohio Attorney before making any decisions on investment vehicles.
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