Convertible Note Agreement (New Zealand)

A convertible note is a form of short-term debt that is designed to convert into equity (shares) in the issuing company upon the occurrence of a specified triggering event — typically a qualifying equity financing round. Rather than negotiating a fixed valuation for the company at the time of the initial investment (which can be difficult for very early-stage companies), a convertible note defers the valuation question to the next equity round. The noteholder (investor) advances funds to the company as a loan, with the expectation that when the company raises a priced equity round, the loan amount (plus accrued interest) will convert into shares at a discounted price compared to what the new investors are paying. In New Zealand, convertible notes are governed by the Companies Act 1993 (which applies when the note converts into shares) and the Financial Markets Conduct Act 2013 (which regulates the offer and issue of financial products including shares). Most convertible note investments are structured to qualify for an FMCA exclusion — typically the 'wholesale investor' exclusion or the 'small offers' exclusion — to avoid the requirement for a full product disclosure statement.

A valuation cap and a conversion discount are the two primary economic protections built into a convertible note for the noteholder (investor). The conversion discount is a percentage reduction (typically 10%–30%) applied to the price per share in the qualifying equity round when calculating the price at which the note converts. For example, with a 20% conversion discount, if new investors in the qualifying round pay NZD $1.00 per share, the noteholder's note converts at NZD $0.80 per share, rewarding the noteholder for the earlier risk taken. The valuation cap is a maximum company valuation used to calculate the conversion price. If the company's valuation in the qualifying round exceeds the cap, the noteholder converts at the cap-derived price rather than the (higher) round price — even after the discount. For example, if the valuation cap is NZD $3,000,000 and the company raises at a NZD $6,000,000 valuation, the noteholder converts at the cap price rather than the round price. The lower of the cap-derived price and the discount-derived price applies in most standard convertible note agreements. Together, these mechanisms reward early investors with a better effective price per share than later-stage investors who invest at the qualifying round.

If a New Zealand convertible note reaches its maturity date without having been triggered by a qualifying equity round, the parties must deal with the outstanding note amount (principal plus accrued interest). There are three common outcomes, which should be addressed in the note agreement. First, the company may be required to repay the principal and all accrued interest — this is the simplest outcome but can create a cash flow burden for an early-stage company. Second, the note may be designed to convert into shares at the maturity date using the valuation cap as the basis for the conversion price — this is common where both parties prefer equity to repayment. Third, the parties may agree to extend the maturity date by mutual consent, giving the company more time to complete a qualifying round. In practice, many convertible notes in New Zealand are extended past their original maturity date by agreement. If the company cannot repay and cannot raise equity, the noteholder's position will depend on the note agreement's default provisions and any security interest registered under the Personal Property Securities Act 1999.

Yes. Both the issue of the convertible note (as a debt security) and, on conversion, the issue of shares (as an equity security) are regulated financial products under the Financial Markets Conduct Act 2013 (FMCA). An offer of financial products to the public in New Zealand generally requires the issuer to prepare and register a full product disclosure statement (PDS) with the Financial Markets Authority (FMA). However, most convertible note investments in New Zealand qualify for one of the FMCA's exclusions from the regulated offer regime. The most commonly used exclusions for convertible notes are the 'wholesale investor' exclusion (for institutional investors, professional investors, and high-net-worth individuals who certify they have NZD $1 million or more in net assets or NZD $200,000 or more in annual investment income), and the 'small offers' exclusion (for offers not exceeding NZD $2 million from up to 20 investors in any 12-month period). The note agreement should clearly identify the applicable FMCA exclusion and include any required investor certifications. Failure to comply with the FMCA can expose the issuer to significant penalties and give investors the right to cancel the investment and recover their funds.

The taxation of convertible notes in New Zealand is a complex area that depends on the specific terms of the note and whether it is classified as debt or equity for tax purposes under the Income Tax Act 2007. During the debt phase (before conversion), interest accruing on the note is generally deductible to the company and taxable to the noteholder under the financial arrangements rules in subpart EW of the Income Tax Act 2007. If the interest rate is below the prescribed rate for the applicable tax period, Inland Revenue may require interest to be imputed at the market rate. On conversion, the tax treatment of the exchange of the note for shares depends on whether the financial arrangements rules apply to the transaction and whether any gain or loss is recognised on conversion. The ACRS (Accrual rules) and the Taxation (International Taxation, Life Insurance, and Remedial Matters) Act 2009 may also be relevant for convertible notes held by non-resident investors. It is strongly recommended that both the company and the noteholder obtain independent tax advice from a New Zealand tax adviser before entering into a convertible note arrangement, particularly where the noteholder is a non-resident or where the note is material in value.