One disadvantage of S corps is they only have the ability to issue one class of stock. While this makes raising capital less attractive, there’s another instrument, convertible notes, which is commonly used among investors and startups. In addition, these instruments aren’t considered equity for tax purposes. Sounds great, but can S corps issue convertible notes?

What are Convertible Notes?

Key Features of Convertible Notes

1. Debt That Converts to Equity: Initially, the investment is structured as a loan, with an agreement that it will convert into equity during a future financing round, typically when more established investors come in during a Series A round.
2. Valuation Cap and Discount Rate: To compensate early investors for their risk, convertible notes often include a valuation cap or a discount rate, or sometimes both.
3. Interest Rate: Convertible notes accrue interest over time. 
4. Maturity Date: Unlike typical loans, convertible notes have a maturity date by which the note must either convert into equity or be repaid. If a specified conversion event (like a subsequent funding round) hasn’t occurred by the maturity date, the company and the note holders might negotiate an extension, conversion based on a pre-determined formula, or repayment.

How Convertible Notes Benefit Startups

• Avoid Valuation Disputes: Early-stage startups often find it challenging to set a fair valuation. Convertible notes allow them to delay valuation until a later funding round when more information is available to accurately assess the company’s value.
• Simplicity and Lower Costs: The legal and financial complexities are typically lower with convertible notes compared to equity financing, making it quicker and less expensive for startups to arrange.
• Flexibility: Convertible notes provide a flexible financing instrument that can be beneficial during negotiations with early investors.

Convertible notes are particularly useful for companies that need quick funding and are confident in their ability to raise more money in the future. 

Can S Corps Issue Convertible Notes?

1. The language within the convertible note agreement cannot resemble an equity agreement (for the initial note) more than debt. If so, it would violate the single class of stock requirement.
2. Assuming the note converts to preferred shares, the entity would be required to change structures from an S corp to a C corp prior to the equity conversion. 
3. If the note converts to common stock (while rare, it is possible), the number of shareholders would have to be 100 or less. Additionally, all shareholders would have to be U.S. citizens or residents (no entities or foreign shareholders).