Introduction

When a startup with a convertible note faces a clause for automatic conversion to common stocks upon maturity, but there is no mention about the valuation for conversion, it can lead to significant complications. This article explores potential solutions and considerations to address this issue, ensuring fair outcomes for both parties involved.

Understanding the Issue

The situation described involves a startup that has issued a convertible note with an automatic conversion clause at maturity. However, the lack of a specified valuation for conversion creates uncertainty and potential misalignment between the startup and the investor.

Common Problems

It is unusual for a convertible note to have an automatic conversion clause without specifying the conversion price or method. If the note does not mention a valuation, it may be considered incomplete or invalid. Both the investor and the company are expected to be aware of the terms they sign, which underscores the importance of clear and detailed agreements.

Legal and Practical Approaches

Option 1: Arbitration and Repayment of Loan Principal Plus Interest

One practical approach is to seek arbitration. The terms of repayment can be established based on an agreement between the parties. This may involve offering repayment of the loan principal plus interest. Such an approach involves the following steps:

Consulting legal counsel to draft the arbitration agreement. Presenting the case for a fair and equitable resolution. Demonstrating the company's ability to repay the loan.

Option 2: Professional Appraisal and Conversion into Equity Shares

An alternative approach is to hire a professional appraiser to estimate the company's valuation and stock price. This can help determine the fair market value of the common stock. Once a fair value is established, the principal plus interest can be converted into equity shares. This approach ensures transparency and fairness:

Hiring a certified appraiser to assess the company's financial health. Based on the appraisal, converting the principal plus interest into equity shares. Presenting the appraisal report to the investor for review.

Considerations and Recommendations

Handling a hostile investor lawsuit or threat effectively requires a thoughtful and strategic approach. Here are some key considerations:

Contract Clarity: The importance of a well-drafted contract that includes all necessary details, particularly valuations. Legal Advice: Seeking legal counsel to navigate the complexities and challenges of such a situation. Working with a lawyer is not just advantageous; it is essential. Confidentiality and Open Communication: Engaging in candid and confidential discussions with the investor's lawyer to understand their intentions and concerns. Hosting Terms and Equity Valuation: If the company is close to generating revenue and there is a potential for new investment, consider inviting a new investor to negotiate better terms and potentially buy out the hostile investor.

Conclusion

The automatic conversion of a convertible note without a specified valuation can lead to significant challenges. Whether through arbitration, professional appraisal, or other means, ensuring a fair and transparent resolution is crucial for both the startup and the investor. Consulting with legal experts and seeking professional valuations can help navigate these complexities, ultimately leading to a favorable outcome for all parties involved.