In this week’s segment on capital raising, we want to talk about something that’s really a tax issue as well as a capital raising issue. When you decide to go raise capital, there’s a number of different ways you can do it. You can raise debt (borrow money) or you can raise equity, such as sell stock and sell rights to stocks and things like that. But many times we get a little too clever, and we come up with a security or an instrument that’s a little bit of debt and a little bit of equity. The convertible note is the classic example of this, and it’s a great instrument. Many people have used it, and it’s effective because early investors like convertible notes, usually because they get a bit of a discount and can collect a little interest along the way. It’s an attractive instrument, but there’s a complication here that you need to be mindful of when you’re raising capital!
The IRS makes a determination whether or not your instrument is debt or equity, and it can have tax consequences to your investors when they do that conversion. There have been many, many, many court cases on this over the years, but it’s still a judgment call. Several factors come into play, like the length of the term of the note, the nature of the debt, the degree of the participation and continuing interest a debt holder might have, the extent of proprietary interest compared to the similarity of a cash payment, etc. There have been many creative instruments over the years, so just be mindful that you know some of these hybrid types have consequences, especially to the investors. You don’t want them getting mad at you if they suddenly have a tax bill because you did exactly what you intended to, which was exchange their debt for equity, or vice versa.
Be mindful! We love discussing these things because it’s very specific to the situation of a specific company, so if you need to mull this over, give us a holler.