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Convertible Promissory Notes; Flexible Financing Options

I have explored the topic of promissory notes in previous articles. This analysis shall specifically concentrate on convertible promissory notes.

As a reminder, a promissory note is a written promise by a person, persons or entity to pay a specific amount of money (called “principal”) to another, usually to include a specified amount of interest on the unpaid principal amount.  In addition, a promissory note will include the basic specifics of the debt, including the debtor and creditor, when payment or payments are due, interest rates, if the debt is secured, and whether the debt may be converted into stock or other equity.  A promissory note that may be converted is often referred to as either a debenture or a convertible promissory note.

Notes Can Be Sold or Assigned

Unless specifically prohibited in the language of the note, a promissory note is assignable by the lender.  That is, the lender can sell or assign the note to a third party who the borrower must then repay.  However, a promissory note is never assignable by the borrower, without the express written consent and approval of the lender.  Moreover, convertible promissory notes are generally not assignable unless the third party meets specific criteria.  This is because a convertible promissory note is generally an investment decision (i.e. it can be converted into equity) and the exemption relied upon by the borrower may be limited to the lender meeting certain eligibility.  For example, generally lenders in a convertible promissory note must be accredited and not be disqualified from participating in stock offerings, such as by having a penny stock bar.

Flexibility of Financing

Convertible promissory notes offer flexibility for financing for a small public company.  Generally both the investor/lender and public company/borrower anticipate that the conversion option will indeed be used for repayment of the debt.  However, the lender has the comfort of knowing that if the conversion option is not viable, the debt is still owed in cash.  Securities laws require that there either be an effective registration statement or exemption to registration at the time of conversion.

Securities Act Rule 3(a)(9) is the exemption usually relied upon, however, this rule does not address whether the securities issued in the conversion are restricted or freely tradable.  Section 3(a)(9) of the Securities Act of 1933, provides an exemption from the registration requirements for “[E]xcept with respect to a security exchanged in a case under title 11 of the United States Code, any security exchanged by the issuer with its existing security holders exclusively where no commission or other remuneration is paid or given directly or indirectly for soliciting such exchange.”  Since Section 3(a)(9) is a transactional exemption, the new securities issued are subject to the same restrictions on transferability, if any, of the old securities, and any subsequent transfer of the newly issued securities will require registration or another exemption from registration.  Since the new securities take on the character of the old securities, tacking of a holding period is generally permitted allowing for subsequent resales under Rule 144 (assuming all other conditions have been satisfied for use of such rule).

Registration Statements Must be Effective

An effective registration statement or meeting the requirement of Rule 144 are necessary to ensure that when converted, the lender receives freely tradable securities and thus control over its risk.  That is, if the securities are freely tradable, the investor has the right to sell the securities immediately to recoup the loan made to the public company and potentially make a profit on their investment.  Accordingly, a conversion option would not be viable if there was no effective registration statement in place for the underlying securities, or if Rule 144 was unavailable as to the underlying securities.

Generally the lender in a convertible promissory note requires that the small public company file a registration statement to register the underlying securities.  Upon effectiveness of the registration statement, the lender will convert all or a portion of the debt, depending on the negotiated terms of the note, into common stock and sell the stock in the public market place to recoup their original investment.

Convertible Promissory Notes and PIPEs

A convertible promissory note is often the investment vehicle used in PIPE financing.  The convertible note will set a conversion price which is negotiated between the lender/investor and borrower/public company at the time of issuance.  Generally, the note is convertible into common stock at a discount to the market price of the stock at the time of conversion.  In my experience the negotiated discount can vary widely.  A public company with greater liquidity, strong market support, strong financial statements, and the like, would be in a position to negotiate a smaller discount such as 15% – 25%, whereas a public company without these benefits may have to agree to a much higher discount such as 50%-75%.

Although on its face small public companies may be enticed to except this type of financing (they can obtain cash now that is paid back in stock later…), there are some disadvantages that they should be aware of.  For instance, a convertible promissory note which is partially converted or converted in tranches, has the tendency to drive the price of a security down while exponentially increasing the amount of stock in the public float.  For example, if the security is priced at $1.00 and the lender/investor converts $10,000 of debt and immediately sells those securities into the public market, that very selling pressure may drive down the price.

When the lender converted the next $10,000 in debt at a lower price, say $.80, they would get more common stock to cover the same amount of debt.  Upon selling this stock, again, the selling pressure would drive down the price.  as the lender/investor continued to convert into more and more stock to cover the same amount of debt, and sell such stock, the price would be driven down further and further.  Moreover, the amount of stock in the public float would continue to increase, resulting in dilution to the current shareholders and making it much more difficult for the same stock to see an upward movement in its price.

Market Priced Conversion Formulas

Because a market price-based conversion formula can lead to dramatic stock price reductions and corresponding negative effects on both the company and its shareholders, convertible security financings with market price based conversion ratios have colloquially been called “floorless”, “toxic,” “death spiral,” and “ratchet” convertibles.  Commonly public companies complete a reverse split of their outstanding common stock following the completion of a death spiral financing.  In an effort to protect the public markets and existing shareholders from abuses the SEC often limits the amount of stock underlying a convertible promissory note that can be registered at any given time to 30% of the outstanding public float at the time of registration.  The SEC relies on its powers under Rule 419 to limit the amount of securities being registered at any given time.

In summary, convertible promissory notes offer a flexible funding source for small public companies, but as in all funding transactions, the devil is in the details, and a good securities attorney is invaluable.

The Author

Attorney Laura Anthony,
Founding Partner, Legal & Compliance, LLC
Securities, Reverse Mergers, Corporate Transactions

Securities attorney Laura Anthony provides ongoing corporate counsel to small and mid-size public Companies as well as private Companies intending to go public on the Over the Counter Bulletin Board (OTCBB), now known as the OTCQB. For more than a decade Ms. Anthony has dedicated her securities law practice towards being “the big firm alternative.” Clients receive fast and efficient cutting-edge legal service without the inherent delays and unnecessary expense of “partner-heavy” securities law firms.

Ms. Anthony’s focus includes but is not limited to compliance with the reporting requirements of the Securities Exchange Act of 1934, as amended, (“Exchange Act”) including Forms 10-Q, 10-K and 8-K and the proxy requirements of Section 14. In addition, Ms. Anthony prepares private placement memorandums, registration statements under both the Exchange Act and Securities Act of 1933, as amended (“Securities Act”). Moreover, Ms. Anthony represents both target and acquiring companies in reverse mergers and forward mergers, including preparation of deal documents such as Merger Agreements, Stock Purchase Agreements, Asset Purchase Agreements and Reorganization Agreements. Ms. Anthony prepares the necessary documentation and assists in completing the requirements of the Exchange Act, state law and FINRA for corporate changes such as name changes, reverse and forward splits and change of domicile.

Contact Legal & Compliance LLC for a free initial consultation or second opinion on an existing matter.


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