A convertible note is a debt arrangement, in which a company borrows funds from a lender for a period of time. The debt under the note may be repaid, or may convert into cash or shares at the end of the term, or on the trigger of an event (such as a sale of the business, or initial public offering).

A convertible note arrangement may provide benefits to both parties, however the terms of the note must be considered carefully. Some of the matters to consider are:

• The Lender may be able to gain a return on investment immediately, before the company makes a profit, by requiring the principal plus interest to be repaid, or the interest paid in increments before the end of the term. The interest paid, may be at a higher rate than the interest that would be provided by a bank. The higher rate may incentive the Lender to provide the funds.
• For the company, the arrangement may provide a short term facility. The costs of the loan and the interest paid under the loan may be tax deductable.
• Because the note is regarded as a debt, the Lender may secure payment through registration of its interest on the Personal Properties Securities Register (“PPSR”). This will protect the Lender’s interest if the company proceeds to liquidation prior to repayment. If this occurs, the Lender’s funds will be paid in priority of the registration on the PPSR and before non-secured creditors.
  
  
• At the end of the term or at certain trigger events, the debt may be repaid with interest or the amount converted into equity in the Company.  The terms of repayment or conversion will be at the option of both parties or alternatively, at the option of the Lender or the Company, depending upon what is agreed.
• The timing of the valuation and method must be agreed.   If it is difficult to value the company when the funds are loaned the valuation may occur at the time of conversion.

• The shareholders of the company may maintain control of the company by insisting on the loan being repaid, or alternatively that a separate class of shares be created on conversion of the debt.
• On conversion, the lender will become a shareholder of the company, and must agree to be bound to the terms of the company’s constitution or the shareholders agreement (if there is one).

• Subject to the terms of the note and the issue of equity in the company, entities may need to disclose the issue of the note to shareholders and comply with the Corporations Act 2001 (Cth). 

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