In the world of startups, different legal investment vehicles are used, which are intended to promote the raising of seed capital by offering equity participation to angel investors, venture capital, incubators and accelerators, among others, in order to achieve exponential growth of the business.

Therefore, nowadays, new technologies have revolutionized law, which must adapt to the new reality, in terms of the demand of startups and investors to protect the business relationships they enter into in a faster and more efficient way.

Consequently, there are currently different legal documents, far from conventional documents, which are used to provide certainty and legal security between startups and investors. 

Among these documents we find the the convertible notes, which are the subject of this article. 

The convertible note could be defined as an agreement, since it is a document that creates and transmits rights and obligations, by means of which an investor grants a certain amount of money to a startup for it to grow, and provided that the conditions agreed in the contract are met, this will be converted into capital or participation in the company in the form of shares. 

Convertible notes are debt as well as equity investment instruments that are intended to raise funds from investors who are willing to take a higher risk in a growing company, in exchange for a higher potential reward. 

a.         Legal nature 

Regarding the legal nature of the convertible notes, it is considered that since they are an agreement where commercial acts are agreed, they are commercial contracts.

On the other hand, they are bilateral in nature, since both the creators of the startup and the investors are obliged to comply with different rights and obligations.

Likewise, it is inferred that the convertible notes are subject to a suspensive condition in the event that the conditions agreed therein are fulfilled, the conversion to a share package in favor of the investor will take place or, otherwise, the return of the capital plus the agreed interest.

In this sense, it is noted that the convertible note is a document which allows exercising the conversion to a share package in the future or in its case the payment of the investment as a loan plus the interest agreed therein.

b.        Elements

i.          Investment amount

This refers to the amount of capital that the investor will make available to the startup, which, if the agreed conditions are met, may be converted into shares or, if they are not met, may be returned with the interest agreed in the convertible note.

ii.         Expiration Date

This is the deadline agreed by the parties for compliance with the capitalization conditions agreed within the convertible note; if by this date they have not been complied with, the startup is obliged to pay the amount of the investment plus the agreed interest.

iii. Interest rate 

This is the interest rate or percentage that the company must pay on the capital invested to the investor, in the event that the agreed date has been reached and the conditions have not been fulfilled, or if applicable, which will operate in favor of the investor at the time of converting the note. 

iv.        Maximum Valuation Amount (CAP)

This is the maximum valuation that the startup may reach for purposes of converting the note so that the investment is not diluted.

In this sense, since these are new businesses, the valuation is based on future projections made by the startup, so that the investor will know how much its investment will be worth at the time of converting the note.

In the event that the CAP is reached before the maturity date, the note must be converted.

v. Conversion price

When the convertible note is not subject only to obtaining the maximum valuation, two or more alternative prices may be agreed upon at which the investor may convert its investment into shares in the event that further rounds of investment occur prior to the maturity date of the note.

vi.        Discount

It is a reward to the investor, in which the convertible note agrees a discount on the maximum valuation amount, so that if the CAP goal is achieved, the investor will convert the note on the discount percentage applied to the CAP.

Likewise, it refers that in the event that subsequent investment rounds are carried out and the dilution of its capital is avoided, the discount allows the investor to participate in the new investment rounds applying the discount to obtain a better share package in its favor. 

vii.       Goals

These are the conditions and parameters that must be taken into account at the maturity date of the convertible note, not only referring to the capitalization of the note, but also to other intangible criteria that are necessary to obtain the valuation of the startup.

c.         Conclusion

Therefore, the convertible notes present multiple advantages for startups that seek to raise funds more quickly and efficiently without the need to obtain a total appraisal of the company, since the maximum amount of valuation is made based on future projections.

Therefore, contrary to other legal documents, the convertible notes give the investor the assurance that they will receive the reimbursement of the invested capital plus the agreed interest.

Thus, it is concluded that, in virtue of the market variations from one moment to another, where decisions need to be made promptly for businesses to grow through investment, the convertible note is a great option for startups that intend to provide legal certainty in their relations with investors, because they are flexible instruments and adapt to the needs of each of the parties.

We remain at your disposal for any advice or doubt related to the present:

For more information please contact:

Frida Enríquez

frida.enriquez@vila.com.mx