Many cannabis companies are finding themselves strapped for cash and in need of emergency funding or interim financings between larger equity raises. Often these fast funds come in the form of loans from either existing investors or family and friends. These loans, more often than not, tend to take the form of a promissory note. Promissory notes are instruments that remain on the company books as debt until the indebtedness is: (i) either paid off in principal plus interest to the lender or (ii) converted into equity of the borrower if the note is “convertible”. Often these loans are referred to as “bridge loans” because they bridge the company along to the next step in their business plan by allowing for incremental funding in times of need.
Promissory note instruments can be straight loans with interest that mature on an agreed maturity date and are paid out by the borrower to the lender on such maturity date in principal plus accrued interest or they can (in addition to having an agreed maturity date) be convertible debt instruments that are convertible into equity of the borrower upon the consummation of certain conversion event triggers, such as a future equity financing of the borrower that occurs prior to the agreed maturity date.
Promissory notes are preferable for startup companies for fast funding solutions because:
- They are Simple Cost-Efficient Documents: promissory notes tend to be simple instruments involving less negotiation than an equity financing (which keeps costs of preparation and negotiation down);
- Company Valuation can be Avoided: promissory notes tend to be straight-forward without any need to implement the complicated company valuation metrics requirements that accompany equity financings. Generally, when a company sells equity, it requires determining the value of equity of a company. There is no need to do so when issuing debt instruments because the company simply accepts the funds in return for agreeing to repay them with interest or convert them into equity at a valuation established by a future event (the one exception is if the note has a valuation cap that applies in a conversion event, which companies can avoid by offering a discount to a future conversion price in lieu of offering a valuation cap on conversion);
- They are Sometimes Lower Risk than a Direct Equity Investment: promissory notes are relatively innocuous for investors if the instruments provide for both a maturity payback mechanism (principal plus interest) and a conversion into equity alternative (whereas equity financings require investors to commit to taking an absolute risk in the company, even if it is an early-stage company, at the time of the equity investment); and
- They Often Contain Sweeteners for Investors: promissory notes often offer sweeteners for investors such as valuation caps or discounts which can sway investors to take the early risk for the benefit of converting into equity at a lower price than other future new money equity investors will pay at an applicable conversion-into-equity event provided for in the instrument.
Here at Rogoway Law Group, our corporate and transactional team is ready to help our clients in times of need for fast funds. Companies can benefit from thinking about raising capital in smaller increments when they aren’t quite ready to pitch the big picture in a larger equity round. We understand that the cannabis business is especially risky, often unpredictable, and laden with variables in the compliance landscape that make company forecasts and financial budgets hard to nail down with accuracy. We are available to help with that rainy day, including assisting in obtaining bridge loan financings as described above.