If a company fails before a convertible note converts into equity, several outcomes can occur, depending on the terms of the note and the specific circ*mstances of the failure. Here’s a detailed look at what happens to a convertible note in such a scenario:
### 1. **Convertible Note as Debt**
A convertible note is initially structured as debt, meaning that the investor has lent money to the company with the expectation of repayment or conversion to equity in the future. If the company fails:
- **Default**: The company is typically in default on the note. The terms of the note will specify what happens in the event of default. This often includes acceleration of the debt, meaning the entire principal and any accrued interest become immediately due.
### 2. **Company's Assets**
If the company has any remaining assets upon failure:
- **Liquidation**: The company's assets may be liquidated (sold off) to repay debts. In the case of liquidation:
- **Priority of Claims**: Convertible note holders are creditors and have a higher claim on the company's assets than equity holders. They are typically paid after secured creditors but before common shareholders.
- **Distribution of Proceeds**: If there are sufficient assets, the proceeds from the liquidation will be used to pay off the convertible note holders (principal and accrued interest). However, in many cases, the assets may not be sufficient to cover all debts.
### 3. **No Remaining Assets**
If the company has no remaining assets or insufficient assets:
- **Loss**: Convertible note holders may lose their investment. The note holders can claim the company’s assets, but if the assets are negligible or nonexistent, they may recover little to nothing.
### 4. **Negotiation and Settlement**
In some cases, the company and the note holders may negotiate a settlement:
- **Debt Restructuring**: The company might negotiate with note holders to restructure the debt, possibly deferring payment or converting the debt into some other form of security, though this is less common in the case of outright failure.
- **Settlement**: A negotiated settlement might involve partial repayment or other terms agreed upon by both parties.
### 5. **Legal Proceedings**
If the company goes into bankruptcy:
- **Bankruptcy Proceedings**: The bankruptcy court will oversee the distribution of any assets. Convertible note holders, as creditors, will file claims in the bankruptcy process.
- **Priority in Bankruptcy**: Convertible note holders will be paid according to the priority rules in bankruptcy, generally after secured creditors but before equity holders.
### Summary
When a company with outstanding convertible notes fails before conversion:
- The note is treated as debt, and the company is in default.
- Convertible note holders have a claim on the company's assets, but the actual recovery depends on the availability and sufficiency of those assets.
- Note holders may negotiate a settlement or be involved in legal proceedings if the company goes through bankruptcy.
Convertible note holders should be aware of these risks and ensure that the terms of the note provide as much protection as possible in the event of company failure.
Answered 3 months ago
