Converting Previous Notes: Key Considerations Before Your Priced Round

Before entering a preferred equity priced round, your company likely engaged in several financing rounds using convertible notes. These notes are designed to convert into equity during the priced round, but there are important factors to consider when managing this conversion process.

Principal and Interest Conversion: Managing Obligations

Convertible notes typically accrue interest in addition to the principal amount. When it comes time to convert these notes into equity, both the principal and accrued interest may be eligible for conversion. While your convertible note agreement should outline how interest will be handled, it’s often simpler to pay the interest in cash rather than converting it into equity. This approach can help avoid complicated recalculations that might arise from including interest in the equity conversion.

Tax Implications: Avoiding Unintended Consequences

Cancelling accrued interest in exchange for equity can be considered a taxable event, with the taxable amount equal to the value of the cancelled interest. To avoid potential tax liabilities, some investors may prefer that interest be paid in cash rather than converted into stock. This consideration can prevent unexpected tax burdens for both the company and the investors.

Additionally, the company may face tax reporting and withholding obligations when converting convertible securities into company stock. To ensure compliance, consider implementing a mechanism to collect the necessary tax documentation from investors. This will facilitate tax analysis and help the company meet its withholding obligations.

Consistency in Conversion Formulas: Aligning Terms Across Convertible Securities

If your company issued multiple convertible securities before the priced round, there may be slight variations in the conversion formulas used. To streamline the conversion process and avoid confusion, it’s important to ensure that all noteholders agree to a consistent conversion price. This alignment will help eliminate discrepancies and create a smoother transition to equity.

Conclusion: Preparing for a Seamless Conversion

Converting previous notes into equity during a priced round involves careful consideration of both financial and tax implications. By managing interest conversion thoughtfully, addressing potential tax liabilities, and ensuring consistency across conversion terms, you can facilitate a smooth and efficient transition to equity financing.

As you prepare for this process, work closely with your legal and financial advisors to navigate these complexities and ensure that your company and its investors are well-positioned for success.