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What Are Reverse Convertible Notes (RCNs)?

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by Beatrice Mastropietro · 8 min read
What Are Reverse Convertible Notes (RCNs)?
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The Reverse Convertible Note (RCN) is a hybrid security that combines aspects of debt and equity. The RCN provides the investor with an option to convert their investment into shares in the future, typically upon maturity. This guide will discuss what RCNs are, how they work, and why you should consider investing in them.

On a regular convertible note, the issuer borrows money from the lender to finance his company. If everything goes well, the borrower will eventually repay this loan with a percentage of interest in addition. With Reverse Convertible Notes (RCNs), the situation is different. When you acquire one of these securities (or security tokens), you invest money in the issuer company, but it is not a debt-type agreement like with convertible notes. The RCN is nothing more than equity security that you can convert into tokens or fiat currency under certain conditions.

The purpose of these tokens was to create a new way of financing companies by using blockchain technology and smart contracts, eliminating intermediaries, and making everything straightforward for startups and investors.

Reverse Convertible Notes Definition

Reverse Convertible Notes (RCN) are a highly flexible instrument often used as an interim step between pure equity and debt financing. RCNs can also be referred to as “top-hat” convertible securities, as the notes do not have a predetermined conversion ratio as with traditional convertible securities. This is because they share both straight debt and common stock characteristics. In particular, they allow for repayment in cash or shares at the issuer’s discretion and usually convert into common stock automatically upon issuance unless otherwise specified by the investor and issuer. RCNs offer investors and issuers greater flexibility than traditional convertible securities, but still provide investors some protection from dilution if the company performs poorly.

Reverse Convertible Notes (RCNs) are debt or equity securities with an embedded option (conversion option) that gives the holder the right to convert the note into shares of common stock in some future time period. This type of security is usually issued by startup companies when they cannot issue securities directly in public markets but may be allowed to do so after private issuance. The conversion price can be set either at WEISS or at market prices, which are typically lower than the market prices for shares of stock on the primary exchanges.

\For example, suppose WEISS determines that your company’s common stock is worth $1 per share today and sets your investor’s conversion price at 25 cents per share. In that case, you will have to issue new capital immediately at a valuation below this level to raise capital. Your company can issue a convertible note for $1 million with a conversion price of 25 cents per share so you can immediately protect investors the capital without having to receive the WEISS calculation of the company’s current valuation. But when you go to market, your investor would sell their shares at market prices and split up his/her holdings in an amount equal to the initial amount invested divided by that lower market price.

How Do Reverse Convertibles Work?

Reverse Convertible Notes (RCNs) are commonly known as convertible loans or notes. These financial instruments act as a loan to an investor. Also, they offer the opportunity for that investor to convert their investment into shares of the company they are investing in. The process is somewhat analogous to investing in stock through buying on margin, but RCN investors can purchase them without putting up any collateral at all.

The Reverse Convertible Note business plan has two sections. The first one is how much money you need and the second one is what you will do with it once you get it. Just like ordinary businesses, crowdfunding requires proper planning if your campaign aims to succeed. You’ll need to explain who your customer is, how much it will cost you to develop your product or service, and how you plan to make a profit. If you are successful, you will have the potential to return ten or even one hundred times your initial investment.

In its most basic form, an RCN is a loan that allows the lender (investor) to convert their loan into shares of the company’s stock at some future date for a predetermined price-per-share, less than what it would cost them to buy on the market today. Then they can sell the shares whenever they like. The conversion option should be set at a fixed price no matter how much time passes until the maturity date, so investors won’t need to worry about whether they bought too early or waited too long before converting their notes into equity. This feature eliminates any risk the investor might be exposed to due to volatility in the price of the company’s stock. The issuer (company) can choose whether or not it will provide additional securities and at what time and price, if any. In practice, the terms are negotiable.

RCN Payouts

Reverse Convertible Notes Payouts act like traditional payout notes, except they convert upon repayment rather than at maturity. In other words, you would have potential liability for repayment until an amount greater than your investment was repaid.

In effect, the investor borrows from the company over a long term or receives dividends as if they had converted or sold their shares immediately after investing. The key risk with reverse payout notes is a liquidity crunch leading to forced conversion to equity at below-market rates. This can be mitigated by ensuring that investors have adequate exit strategies built into their investment agreements and do not invest more money into a company that they will not be able to repay upon maturity.

Convertible Payout Notes are slightly more complicated than reverse payout notes and require specific repayment conditions. They will convert at a fixed price but only if certain milestones or targets (usually related to profitability and tangibles such as revenue, number of users, etc.) have been met. If the milestones are not reached, all outstanding amounts, including interest, are due immediately. These kinds of deal structures can work very well, as they give companies some certainty that they will achieve the necessary results prior to their equity being diluted away by conversion into shares at such low prices.

The downside of these deals is that investors will be more aware of the risk associated with investing in companies that have not yet achieved profitability and will demand a higher interest rate to compensate for that risk. Payout notes can also trap companies into unprofitable business models and prevent the exit strategy that is so critical to achieving new investment at reasonable valuations.

Risks Associated with RCNs

The first thing to note is that RCNs are not a product of equity crowdfunding platforms but traditional private placement markets. However, they recently have been increasingly offered through these platforms due to their flexible nature and higher potential for returns.

RCNs are a type of debt security that exchanges an investor’s loaned capital for company stock, with the promise of receiving back both the initial investment along with 20–50% profits on top. This makes them similar to convertible notes in that investors receive both interests on principal and some form of equity position. But unlike standard convertible notes, Investors do not have an obligation to convert their message into common stock, nor are they required to hold onto it until after its term expires. Instead, the investor has the option to settle (or exercise) their note at any point before its maturity date, which is usually set anywhere between 1–3 years, for cash plus 20–50% of the profits on top. This makes them ideal for early-stage companies looking to boost their capital investment without selling securities that will eventually convert into common stock (this means avoiding future lockup periods) or an investor who wants to benefit financially if/when a company succeeds but doesn’t want to be tied down by ownership responsibilities.

The main risks associated with RCNs are as follows. Firstly, if a company goes bankrupt or out of business before its maturity date, all funds invested in it are lost. Secondly, there is no secondary market for these notes, meaning if the note holder has to sell their interest before maturity, they will likely receive close to 20–50% of its initial value. Further, if a company goes up in value after receiving investment but then falls on hard times and becomes insolvent, no built-in reimbursement mechanism guarantees investors will get their original principal back first. This means that only afterward can they potentially recover any profits made on top of it.

Besides, some RCNs are structured. Suppose the issuing company fails to meet certain milestones set by the investor, say ones associated with financial performance or business expansion. In that case, they forfeit all future interest payments until such milestones are met. Though this isn’t particularly common, it does exist and would require investors to be aware of any such stipulations that may apply before investing in them. Finally, since RCNs are debt instruments, they can also increase a company’s risk profile without increasing its capital by simply adding another creditor on top of existing shareholders.

Conclusion

Reverse convertible notes (RCNs) have a number of advantages for both the founders and investors in a startup. Founders can benefit from their relative simplicity, long maturity, and lack of dividend payments or interest requirements. Investors get many of the benefits of a classic convertible note, including security and traceability, while also participating in future value increases if the company is successful. Reverse convertible notes are gaining popularity quickly as an alternative to standard convertible notes.

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FAQ

What are Reverse Convertible Notes (RCNs)?

Reverse Convertible Notes (RCNs) are debt or equity securities with an embedded option (conversion option) that gives the holder the right to convert the note into shares of common stock in some future time period. This type of security is usually issued by startup companies when they cannot issue securities directly in public markets but may be allowed to do so after private issuance.

How do RCNs work?

Reverse Convertible Notes (RCNs) are commonly known as convertible loans or notes. These financial instruments act as a loan to an investor. Also, they offer the opportunity for that investor to convert their investment into shares of the company they are investing in. The process is somewhat analogous to investing in stock through buying on margin, but RCN investors can purchase them without putting up any collateral at all.

How are RCN payouts determined?

The RCN payouts depend on the value of the underlying stock and the volatility of that stock. It is expressed as a percentage, usually between 30–100%. The higher value of those two factors, the larger your payout will be.

Is it risky to invest in RCNs?

RCNs typically have high commission fees and are considered by some money managers to be highly risky and even toxic assets.

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