Twelve things we check before taking a convertible note to lenders

Conversion price against the actual trading tape, not the stated reference

The first check is arithmetic, not judgement. A term sheet will quote a conversion price by reference to a stated period — often a volume-weighted average over ten or twenty trading days — but the reference period chosen can be picked to flatter the discount. We rebuild the calculation from the raw tape ourselves, using the actual print history, rather than accepting the issuer's own summary of it.

Thinly traded names make this worse. A short reference window on a stock with low daily volume can be moved by a handful of trades, deliberately or not, so the stated conversion price may not reflect anything a lender could actually transact at. We flag any period where average daily volume would not support the note's own conversion size without materially moving the price.

Where the tape shows sustained divergence between the reference price and the current price, that gap becomes the first line item in the credit memo, because it directly changes the effective discount a lender is being asked to accept.

Whether the conversion valuation is pre- or post-money to the note itself

Term sheets are frequently ambiguous, whether by drafting habit or by design, about whether the conversion price is calculated before or after the note's own principal and accrued interest are added to the capitalisation. The difference changes the effective ownership a lender receives on conversion by a measurable amount, and it is rarely obvious from a single read of the document.

We resolve this by modelling both interpretations against the stated cap table and comparing the resulting share counts. If the two readings produce materially different outcomes, that is evidence the term sheet needs to be redrafted before it goes anywhere near a lender, because an ambiguity that favours the issuer in negotiation will not survive scrutiny at close.

This check also interacts with warrant coverage, where warrants are priced off the same conversion mechanic. An error here compounds across every instrument attached to the note rather than staying contained to the note itself.

Original issue discount measured against the stated use of proceeds — what actually lands in the company

Original issue discount reduces the amount a company actually receives relative to the face value of the note it issues. A note with a face value of 10 and an original issue discount of 8% delivers 9.2 to the company before any further fees, and every subsequent cash flow projection should be built from that lower figure, not the face value.

We reconcile the discount, placement fees and any advisory fees against the stated use of proceeds line by line. Where the sum of deductions leaves materially less cash than the use-of-proceeds narrative implies is needed, that gap is a solvency question for the lender, not a rounding error for the borrower to explain away later.

This check also exposes notes where the discount has been structured to compensate for weak underlying security, which is a separate and more serious finding covered in the next section.

Whether the security description in the term sheet describes any security at all

Senior secured is a label, not a fact, and we test it as one. A term sheet that references a general security agreement without identifying the specific collateral, its priority, and the jurisdiction of perfection is describing an intention rather than a security interest. We ask for the actual filed instrument, not a summary of it.

Intercreditor position matters as much as the collateral itself. A note described as senior secured behind an undisclosed working capital facility with its own floating charge is not senior in any meaningful sense, and the intercreditor agreement — where one exists — is the only document that settles the point.

Where no security has actually been perfected at the time the term sheet is issued, we say so plainly, because a lender pricing the note as secured debt when it is functionally unsecured is pricing the wrong instrument.

We also check what constitutes an event of default under the security documents specifically, since default triggers under the note and under any security agreement do not always match.

Guarantors, intercreditor position, and what constitutes an event of default

A guarantee is only as good as the guarantor's own balance sheet and the enforceability of the guarantee in the relevant jurisdiction. We ask for the guarantor's most recent financial statements and confirm the guarantee has actually been executed and registered where registration is required, rather than merely referenced as forthcoming.

The intercreditor agreement, where multiple creditors sit behind the same obligor, determines who gets paid first and in what order enforcement actions can be taken. We read it for standstill periods, turnover provisions and any carve-outs that could subordinate the note holder in practice even where the term sheet describes the note as senior.

Events of default across the note, the guarantee and any intercreditor documentation need to trigger consistently. Where a default under one document does not cross-default the others, a lender can find itself holding a technically defaulted note with no practical remedy available.

Lead investor's committed amount versus their intended sell-down

A lead investor's role in a convertible note is partly signalling — other lenders take comfort from a credible lead having done its own diligence and committed real capital. That signal is worth less if the lead intends to sell down most of its position immediately after close, which changes its economic exposure to the credit it is supposedly vouching for.

We ask directly what portion of the committed amount the lead intends to hold to maturity and what portion is placed with the expectation of near-term syndication. A lead retaining a small fraction of a large headline commitment is providing less alignment than the headline number suggests.

This check is straightforward to run and frequently skipped, which is precisely why it belongs on the list.

Target acquisition multiple on total consideration, including earnout and seller paper

Where note proceeds fund an acquisition, the multiple quoted in the deck is usually calculated on upfront cash consideration only. We recalculate it on total consideration, adding any earnout at its full potential value and any seller paper at face value, because that is the number the target's shareholders are actually being paid and the number the deal ultimately has to earn back.

Earnouts structured around aggressive post-close targets frequently push the effective multiple materially higher than the headline figure once modelled in full, and a lender pricing off the headline multiple is pricing a different, more attractive deal than the one actually being financed.

We also check whether the earnout is contingent on performance the acquirer controls, since an earnout the buyer can influence unilaterally is functionally deferred consideration rather than a risk-sharing mechanism.

Quality of earnings adjustments and which add-backs survive

A quality of earnings review exists to separate sustainable earnings from adjustments made for the purpose of the transaction. We ask for the full list of EBITDA add-backs, not the summary total, and test each one against a simple question: would this cost recur if the business continued operating exactly as it has been.

Add-backs for one-off legal costs or a discrete restructuring charge are typically defensible. Add-backs for management fees the new owner will simply reinstate under a different name, or for cost savings not yet contracted or implemented, are not, and we exclude them from the working EBITDA figure regardless of how they are presented in the deck.

The gap between reported and adjusted EBITDA, once add-backs are stripped back to what actually survives scrutiny, is often the single largest driver of whether the target multiple discussed above is defensible at all.

Run-rate revenue claims against trailing actuals

Run-rate revenue — the most recent month or quarter annualised — is a legitimate metric for a fast-growing business, but it is also the easiest number in a deck to distort, whether through a single strong month, a large one-time order, or a change in recognition policy timed to the reporting period.

We reconstruct the run-rate from underlying invoicing or billing data rather than accepting the summary figure, and compare it against trailing twelve-month actuals to establish whether growth is genuine or a step change driven by a single event that will not repeat.

Where the gap between run-rate and trailing actual growth is wide, we ask for the specific driver and test whether it is structural or one-time before it is allowed to inform the credit case.

Internal consistency between term sheet, deck and model

These three documents are typically produced by different people at different times, and it is common for figures to drift between them without anyone reconciling the change. We line up the key numbers — facility size, pricing, use of proceeds, revenue projections — across all three and flag every discrepancy, however small.

A small inconsistency, such as a use-of-proceeds figure that does not sum correctly, is often just an editing error. A larger one, such as a model that assumes a lower discount than the term sheet states, suggests the documents were not prepared with the same set of final terms and need to be reconciled before circulation.

This is a mechanical check, but it is also often the fastest way to find the more serious problems described elsewhere in this list, because a document that has not been checked for internal consistency has usually not been checked for anything else either.

Issuer filer status and reporting history

An issuer's filing history establishes whether it has actually met its disclosure obligations on time, over a period long enough to demonstrate a pattern rather than a single clean quarter. We pull the filing record directly from the relevant registry rather than relying on the deck's characterisation of it.

Late filings, restatements, or gaps in the filing history are each treated as a separate flag, and a pattern of any one of them changes how much weight the rest of the diligence pack can bear, because a lender is ultimately relying on the same disclosure regime going forward.

Where an issuer has previously changed auditors shortly before a restatement, or has a gap in its reporting history that is not explained in the deck, we treat that as requiring direct explanation from management before the note is presented to a lender.

Whether the lead is verifiable and has done comparable deals

The final check returns to the lead investor, this time testing whether the firm and the individuals behind it can actually be verified against a track record of comparable transactions, rather than a general reputation for activity in the space.

We ask for a list of prior convertible note transactions the lead has led, confirm at least a sample of them independently, and check whether those deals performed as represented. A lead whose prior deals cannot be verified, or whose verified deals have a poor outcome record, changes the weight the market should place on their participation here.

Taken together, these twelve checks are designed to be run before a note goes to a lender, not after a lender asks the first hard question, because the cost of finding a problem at that stage is materially higher than finding it now.