What is a security interest in connection with a convertible note?
Takeaway: Security interests give the noteholders a lien over the company’s assets. If the company defaults on the notes, the noteholders can foreclose on the company’s assets. In practice, there is often very little to foreclose on if a startup defaults.
Convertible promissory notes are popular financing tools for startups, providing flexibility and potential returns for both founders and investors. When dealing with convertible promissory notes, it's essential to understand the concept of a security interest and its implications for both parties. In this post, we will explore what a security interest is in connection with a convertible promissory note, how it affects the borrower and the lender, and the key considerations for startups and investors.
Convertible Promissory Notes: A Quick Recap
A convertible promissory note is a short-term debt instrument that allows investors to lend money to startups with the expectation that the loan will convert into equity during a future financing round. This conversion typically occurs at a discount or cap on the conversion price. The note has a maturity date, which is the deadline for the startup to either repay the principal amount and any accrued interest or convert the debt into equity.
Security Interest: Definition and Purpose
A security interest is a legal right granted by a borrower (the startup) to a lender (the investor) over the borrower's assets to secure the repayment of a debt, such as a convertible promissory note. In the event of default or non-payment, the security interest allows the lender to take possession of the collateral (the assets securing the debt) and sell it to recover the outstanding debt.
The primary purpose of a security interest in connection with a convertible promissory note is to provide the investor with an added layer of protection for their investment. By securing the note with a security interest, the investor can potentially recover some or all of their investment in the event that the startup fails to repay the debt or convert it into equity.
Implications for Startups and Investors
The presence of a security interest in a convertible promissory note can have significant implications for both startups and investors:
For Startups: Granting a security interest in a convertible promissory note can make it more attractive to investors, as it provides additional protection for their investment. However, it also encumbers the startup's assets and may limit its ability to secure additional financing in the future. Startups should carefully consider the terms and conditions of the security interest and weigh the potential benefits against the limitations it may impose on their growth and operations.
For Investors: A security interest can provide additional protection for an investor's investment in a convertible promissory note, potentially allowing them to recover some or all of their investment in the event of default or non-payment. However, the investor should also consider the potential challenges associated with enforcing a security interest, such as the costs and complexities of legal proceedings and the potential impact on the startup's operations.
Key Considerations for Startups and Investors
When negotiating a security interest in connection with a convertible promissory note, both startups and investors should consider the following factors:
Type of Collateral: The security interest can be granted over a range of assets, including tangible assets (such as equipment or inventory) or intangible assets (such as intellectual property or accounts receivable). The choice of collateral should be carefully considered, as it will affect the investor's ability to recover their investment and the startup's ability to operate and grow.
Perfection of Security Interest: To ensure that the security interest is legally enforceable, it must be properly perfected, typically through the filing of a financing statement or registration with a relevant authority. Both startups and investors should consult with legal counsel to ensure that the security interest is appropriately perfected and compliant with applicable laws and regulations.
Subordination and Priority: In some cases, a startup may have multiple secured debts (e.g., existing bank debt), and the priority of the convertible promissory notes may need to rank below that of the existing debt.
Conclusion
Understanding the concept of a security interest in connection with a convertible promissory note is crucial for both startups and investors. A security interest can provide added protection for investors while potentially making the note more attractive for startups seeking financing. However, it's essential to carefully consider the terms and conditions of the security interest, as well as the potential implications for both parties. By weighing the benefits and challenges, startups and investors can make informed decisions and structure their financing arrangements to best support the growth and success of the startup.