Five Key Due Diligence Considerations for Convertible Notes

Business investment opportunities require careful due diligence. This also applies to situations where you choose to invest using convertible notes. It is important to gather information about the company, its prospect of success and any future developments of the investment.

This article details what convertible notes are and the due diligence required. It also will explore aspects an investor must consider when choosing to invest in a business.

Convertible Notes

Convertible notes are short-term debt financing instruments that turn into equity at a later stage. When investors loan money to a start-up as debt, instead of getting the principal back with interest, they get their share in equity. Convertible notes are also referred to as debt-equity.

Due Diligence

Legal due diligence refers to the process of collecting the relevant information regarding a legal transaction to assess the risks associated with it. Due diligence should be conducted for all investment opportunities, but it becomes even more pertinent for investing in start-ups. New companies often have no information on external evaluation and investors only have the founder’s claims to rely on regarding the business valuation and its growth potential. Therefore, as an investor, you need to verify and substantiate these claims before proceeding with the investment.

 

Due diligence proves useful for the start-up too. It forces start-ups to formulate relevant documents and action plans that are not only important for their investors, but also their business too. Once the relevant research and information gathering has been done start-ups will provide the relevant facts investors would require for convertible notes.

Due Diligence Considerations

Things to consider when researching your investment:

  • The founders;
  • Relevant experience in the business sphere;
  • Key leadership and team members who will be instrumental to running the business.

Inquiring about the company’s intellectual property and licensing agreements they have with collaborators is also important. Checking whether the start-up has any existing agreements in place with clients, suppliers and service providers would be relevant to you.

Key Considerations Before Investment

Investing by using convertible notes means keeping 5 key things in mind:

1. Understanding the Products and Services

You must gain a thorough understanding of what the business offers and the industry it operates in. Knowing what the business offers to the industry and how it differentiates from its competitors is crucial for a successful investment.

Understanding the company’s competition is crucial. You should ask yourself whether the company offers substantially different products or services from its rivals? Then ask, has the business perfected its product or is it still in the testing phase? Will the business require collaborators to add value to the product or can it survive on its own in the market? Lastly, what are the potential improvement and collaborative opportunities the business can explore?

2. The Company’s Future Plans?

Investors place the most weight on the current and projected profits. A thorough understanding of a company’s financial condition is integral before making a final investment decision. With start-ups, you should also be mindful of what databases are being used for the projections.

From here, you must inquire about any current liabilities, costs, or commitments that the business may have made. This includes accrued salaries, expenses, leases and any related product and service costs. This information will provide a more detailed picture when assessing the venture’s ability to withstand any upcoming downturns or unfortunate circumstances in the industry.

It would also be wise to consider the development of the company’s business and operating model. Identifying how the business plans to evolve, especially in fast paced industries like tech, can help predict the company’s growth prospects and chances of success.

3. What is the Company’s Financial Position?

Collecting and analysing financial information is a key part of any sound investment decision. Gathering all the information and documents possible will help you identify and understand the financial condition of the company. These include the financial statements, business plans and expansion plans and projected statements. You should also inquire about how the business plans on using the new investment funds.

Some start-ups may not have extensive financial records to share, but this should not deter you from doing your own research and thoroughly investigating the business. The company’s ability to maintain narrow margins while proceeding with the launch and growth plans is an important consideration as well.

4. Check the Commercial Terms on the Convertible Notes

Once the convertible notes have been drafted, you should carefully analyse them. The maturity date, principal amount, interest payable, and discount rate should be clearly stated and should be in accordance with the initial negotiations.

5. Rights of the Investor as a Shareholder

The investors will become shareholders once the convertible note converts into equity. All provisions and rights of the Shareholder’s Agreement will be awarded to them. That said, before this occurs, as noteholders the investors may ask for certain provisions and rights.

Noteholders may demand access to information such as periodic financial updates, rights to participate in equity raises in the future and the right to observe board meetings.

Representation and Warranties

As an investor, you may require the relevant representations and warranties to be added to the note document. This gives you peace of mind that the company has the capacity to fulfil a deed. It will also confirm that the note is legally binding and enforceable.

You may also be required to include the appropriate representation and warranties in the note subscription agreement. This would verify that you are eligible to enter into such an agreement as an investor.

Key Takeaways

  • Investing with convertible notes requires due diligence.
  • Performing due diligence results in sound investment decisions and helps to avoid risks and downfalls.
  • Analysing what the business does and offers to its clients, who the collaborators and competitors are and what the future prospects of the business entail are crucial.
  • Researching and studying the financial position of the company and its future plans before proceeding with the investment is essential.
  • Reading and understanding the provisions of the convertible note document thoroughly before signing the agreement is critical.

Seek Legal Counsel

The key to a safe and profitable investment means not only having an understanding of the financial aspects, but also the legal ones. Legal provisions can be tricky to understand and can hinder your investment’s profitability if you fail to negotiate the right deal.

If you are looking to invest in start-ups, seek out one of our solicitors to help you through the process. Our lawyers are experienced commercial law experts who are well-versed with the legalities of startups and their business dynamics. Connect with us today to discuss all your legal concerns.

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Mark Lazarus

Mark Lazarus, the visionary behind the business and the fresh blood of the Lazarus Legal team, Mark (or Laz as he is often known) owes much of his success to his past experiences. And he’s made it his personal goal to bring that wisdom and formula to the firm.

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Five Key Due Diligence Considerations for Convertible Notes