The common understanding of the right to convert debt to equity under a convertible promissory note has shifted following a Nevada county court ruling in Toptal v. Grosz. In the court’s motion granting partial summary judgment, the judge in the case applied California law, and the court found the convertible promissory note in question, which allowed election of conversion 15 days from the maturity date, did not contain language that unequivocally demonstrated the parties’ intent to grant a perpetual option and that the right to conversion therefore expired without exercise on the note’s maturity date. 

The judge took the opportunity to quote colorful language from a Fourth Circuit concurring opinion, “Options in perpetuity [are] about as common as polar bear sightings in Death Valley,” citing Shaver v. Clanton, 26 Cal. App. 4th 568, 578 (1994) (Crosby, J., concurring). 

Where is the departure from established understanding on conversion rights? 

Convertible promissory notes provide an appealing investment instrument for investors and companies because, among other reasons, such notes do not require a company valuation on a price per share basis. Further, investors’ equity stakes are determined at the conversion date, which can be an attractive opportunity for investors when a company’s value-inflection point is trending positively during or prior to the conversion period. Prior to the Nevada court’s ruling, the maturity date for convertible notes represented a right to demand repayment, but not an obligation, and the conversion option remained until a demand for repayment or conversion occurs. The ruling has significant implications for investors’ equity expectations, and convertible notes not exercised prior to the maturity date, or containing language indicating a conversion right subsequent to the maturity date, could leave an investor with a diminished, interest-only return on their investment from potentially risky ventures.  

How can investors protect their equity stakes? 

While the Nevada court’s ruling represents a single state’s departure from established understanding on the right to conversion and may be subject to challenge upon appeal, the case highlights the need for specific language in convertible promissory notes providing for a contractual right for conversion, even after the maturity date. For investors considering a convertible debt investment of holding a convertible note with an approaching maturity date, consultation with counsel is warranted.