The Convertible Note Clause That Would Have Handed Over Control

The situation

Hyun-woo had spent over a decade building a multi-unit franchise operation across the GTA, the kind of business where the real profit comes from tight scheduling, inventory control, and staff rostering across many locations at once. A few years earlier, frustrated with the off-the-shelf software available to franchise operators, he and his spouse Hanna, a technology executive with a background in enterprise software, had built internal tools to solve their own scheduling and inventory problems. Other operators started asking to license the tools. What began as an internal fix became a second business: a software platform sold to other multi-unit operators, run as a family-owned company alongside the original franchise operation, with combined revenues somewhere in the tens of millions.

The software side was growing faster than the franchise side and needed capital to hire engineers and build out a sales team. Hyun-woo and Hanna had been introduced to Tesfay, an angel investor with a background operating and exiting a logistics software company, who offered to invest through a convertible note: a loan that converts into equity, usually at a future financing round or at maturity, rather than the parties agreeing on a company valuation up front. Convertible notes are common for exactly this reason — they let a growing but hard-to-value company raise money without a drawn-out valuation negotiation. Tesfay's lawyer sent over a term sheet and, a few weeks later, a full note. Hyun-woo and Hanna, comfortable with contracts in their own industries but not in venture financing, brought the documents to our team before signing.

What the review found

The term sheet had looked reasonable: an interest rate, a discount rate that would give Tesfay a lower effective price per share when the note eventually converted, and a maturity date a few years out. Discount rates on convertible notes typically reward early investors for taking risk before a company's value is established, and none of that was unusual on its own. The problem was in the definitions section of the full note, the part most people skim past to get to the numbers.

The note defined a "qualified financing" — the event that would trigger automatic conversion of the note into equity — extremely broadly. As drafted, it captured not just a future equity round raised from new investors, which is the normal trigger, but any transaction in which the company took on new financing above a modest threshold. That definition was wide enough to catch an ordinary renewal or expansion of the company's existing bank operating line, the kind of routine refinancing a growing business does every few years without it being a fundraising event at all. If the company renewed its bank facility for more than the threshold amount, the note could convert automatically, handing Tesfay equity at a discounted price without any of the negotiation, valuation work, or board approval that a real financing round would involve.

The second issue compounded the first. The note included a general security agreement clause, requiring the company to grant Tesfay a security interest over all of its assets, registered under the Personal Property Security Act, as collateral for the loan until it converted or was repaid. Hyun-woo and Hanna's existing bank operating line already had its own security interest over company assets, and that bank facility's loan agreement contained a standard covenant prohibiting the company from granting any other lender a competing security interest without the bank's consent. Signing Tesfay's note as drafted would have put the company in breach of its bank covenants the moment it signed, before a single dollar of the new investment even arrived. A covenant breach like that gives a bank the right to call its loan, demand immediate repayment, or restrict further draws — a serious risk for a company whose franchise operations depend on that facility for working capital.

Neither clause was necessarily intended as a trap. Investor-side lawyers often draft convertible notes from templates built for early-stage technology startups that have no bank debt and no operating history to protect, and those templates carry security and conversion language that makes sense for a startup with nothing else pledged and no revenue yet. Applied to an established, revenue-generating family company with its own bank relationship, the same clauses created real conflicts that nobody appeared to have caught on either side.

What we did

1. Mapped the note against the existing bank facility. Before drafting any changes, our team reviewed the company's current bank loan agreement to confirm exactly what the covenants prohibited and what consent process, if any, existed for adding a second lender's security interest. This confirmed the conflict was real, not a theoretical reading of the note.
2. Narrowed the qualified financing definition. We proposed language limiting the automatic conversion trigger to a genuine priced equity financing round from new or existing investors, above a stated minimum raised specifically for that purpose, and excluding debt financing, bank facilities, and equipment or operating lines in the ordinary course of business.
3. Removed the general security agreement. Rather than trying to subordinate two competing security interests, which would have required the bank's consent and added weeks of negotiation, we proposed the note be unsecured, consistent with how convertible notes are commonly structured for companies with an established lender relationship. Tesfay's protection came instead from the conversion mechanics and standard default provisions, not from a claim on company assets.
4. Reviewed the personal guarantee question directly with the clients. The note as drafted did not require Hyun-woo or Hanna to personally guarantee repayment, but we confirmed that in writing rather than assuming it, since personal guarantees are common enough in smaller private financings that it needed to be checked rather than presumed absent.
5. Sent a marked-up note back with a short explanatory memo. Rather than a lawyer-to-lawyer redline with no context, we gave Hyun-woo and Hanna a plain-language summary of each change and why it mattered, so they could speak to the reasoning directly with Tesfay if he had questions, which kept the negotiation collaborative rather than adversarial.

The outcome

Tesfay's lawyer accepted the narrowed conversion trigger without objection once it was explained that the broad version would have put the company in breach of its own bank covenants — a result that served nobody, since a bank calling its loan would have been bad for Tesfay's investment too. The security interest took a little longer to resolve; Tesfay's initial instinct was that an unsecured note left him with less protection. Our team walked through the alternative protections already built into the note — the conversion rights, the interest accruing until conversion, and standard default provisions that would apply if the company missed payments or breached other terms — and Tesfay's lawyer agreed the unsecured structure was standard for a note at this size and stage.

The final note closed roughly six weeks after the first draft, with an investment in the mid six figures flowing to the company for engineering hires and a sales team lead. No conversion was triggered, no bank covenant was breached, and no security interest was ever registered against the company's assets. Because the flawed terms were caught during review rather than after signing, there was no dispute to resolve, no default to cure, and no negotiation with the bank required — the entire risk simply never materialized. Hyun-woo and Hanna went into the relationship with Tesfay on terms that reflected the company they actually ran, not a generic startup template, and the software business has continued raising smaller top-up investments from the same investor group on the corrected terms.

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