Right to convert: Overview, definition, and example
What is the right to convert?
The right to convert is a contractual provision that allows one party, usually an investor, to convert one type of financial interest (such as preferred shares or a loan) into another type, typically common shares. This right is often found in investment agreements, convertible loan agreements, and shareholder agreements, giving investors the option to switch their holdings into equity under specific conditions.
Why is the right to convert important?
The right to convert is important because it provides flexibility and potential financial benefits. For investors, it offers the opportunity to gain equity ownership if the company performs well. For businesses, it can be a way to attract investment without immediately giving up ownership, as investors may start with a loan or preferred shares before converting into common equity.
A well-defined right to convert clause protects both parties by setting clear terms, such as conversion rates, timing, and any restrictions. Without it, disputes could arise over when and how conversion occurs.
Understanding the right to convert through an example
Imagine a startup receives a $500,000 investment through a convertible note. The agreement states that the investor has the right to convert the loan into common shares at a valuation of $10 per share when the company raises its next funding round.
A year later, the startup secures a new investment, triggering the conversion right. The investor exercises this right, exchanging the $500,000 loan for 50,000 common shares ($500,000 ÷ $10 per share), becoming a shareholder instead of a lender.
In another scenario, a private company issues preferred shares to early investors, giving them the right to convert into common shares if the company goes public. When the company launches its IPO, investors convert their preferred shares into common shares, gaining voting rights and liquidity.
An example of a right to convert clause
Here’s how a right to convert clause might appear in a contract:
“The Holder shall have the right, at its sole discretion, to convert all or any portion of the outstanding principal and accrued interest of this Note into common shares of the Company at a conversion price of [Insert Price] per share, subject to the terms and conditions set forth herein.”
Conclusion
The right to convert allows investors or creditors to switch their financial interest into equity, offering flexibility and potential upside. It benefits investors by providing an opportunity to gain ownership and benefits businesses by attracting funding while delaying dilution.
For anyone entering a contract with a right to convert, it’s essential to clearly define the terms to avoid future disputes and ensure a smooth transition from debt or preferred shares to common equity.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.