When negotiating convertible notes, parties typically focus on the terms of conversion upon an equity financing, most notably the discount and valuation cap.  This is understandable inasmuch as the not-so-hidden secret of convertible notes is that no one wants the notes to ever get paid.  The investors are not seeking interest on their investment.  The goal is for the company to attract venture capital investors in the near future, do a priced round and then to have the notes convert into that round at a discount.

Not enough attention, however, is paid to what happens upon maturity, assuming a qualified financing, non-qualified financing or corporate transaction has not occurred that would result in conversion prior to maturity.  As a general matter, three possible scenarios could occur upon maturity of a convertible note: conversion into common, repayment of the note and extension of the maturity date. 

A recent case in Delaware involves a dispute between a company and its convertible note investors over the noteholders’ rights upon maturity.  The case serves as a cautionary tale to investors and companies alike as to the importance during the negotiation process of paying close attention to what happens upon maturity. At the risk of getting tedious, the background details are worth reviewing.

Background

The case involves Vistar Media, Inc., an advertising technology company in the out-of-home advertising space.  In 2012, it raised approximately $500,000 through the sale of convertible notes, primarily to friends and family (the “First Round Notes”).  The First Round Notes provided for conversion upon the maturity date of January 31, 2014 into shares of common stock at a price per share based on a pre-money valuation equal to $5 million.  Indeed, the First Round Notes did convert into common without controversy on the maturity date.

In late 2013, Vistar needed additional funding.  It initially received term sheets from two venture funds for equity funding but the deal fell apart over valuation and dilution.  So Vistar pivoted to doing another round of convertible notes, this time targeting strategic ad-tech investors as well as VCs and angels.  Vistar offered the same terms as the First Round Notes, including conversion on maturity, but increased the valuation cap from $5 million to $6 million.

In the negotiation that followed, Valhalla Partners II, L.P. emerged as the de facto lead investor.  Valhalla rejected Vistar’s proposed terms regarding maturity (conversion into common) for the new notes (the “Second Round Notes”), asserting that conversion into common at maturity wasn’t market, and instead countered that upon maturity, the holders would have the option either to have the notes repaid or to extend the maturity date.

Vistar counter-offered with a revised draft of the note, which it circulated under cover of an email that said the revised draft “included the changes requested by Valhalla”.  The revised draft, however, provided that if no equity financing would occur first, the holder at maturity would have the option either to have the note repaid or to convert into common.  Unlike Valhalla’s counter-offer, there was no right to extend in Vistar’s revised draft.

Valhalla then countered with a final draft under cover of an email stating it had just “cleaned up some of the language”, but its actual draft removed the option to convert upon maturity, and instead provided that, subject to the conversion provisions (mandatory upon a prior Qualified Financing and optional upon a prior Non-Qualified Financing), the note would be simply “payable” on the earlier of maturity, sale of the company and an event of default. Valhalla’s final draft had no option at maturity to convert or extend. Here’s the relevant excerpt from the redlined version of Valhalla’s revised draft:

“This Note shall have a maturity date of September 30, 2014. If a Non Qualified Financing has occurred but the Notes have not yet been converted, then at maturity (the Maturity Date”). Subject to the provisions related to the conversion of this Note, the outstanding principal and interest underbalance of this Note will convert into the Non Qualified Financing Securities as defined below. If a Non Qualified Financing has not occurred, then at maturity the outstanding principal and interest under this Note will, at the discretion of the Holder, be repaid in full or convert into shares of common stock at a price per share equal to a pre money valuation equal to $6.0 million. If the Holder elects to be repaid in full, the Holder must provide written notice to the Maker by July 1, 2014., together with interest accrued and unpaid to date shall be payable the earlier of (x) the Maturity Date, (y) a Sale (as defined below or (z) an Event of Default (as defined below).”

Valhalla’s final draft was accepted by Vistar and the other investors. The maturity date of the Second Round Notes was identified as September 30, 2014.  The initial closing of the Second Round Notes occurred in December 2012 with additional closings in 2013.

In October 2014, Vistar emailed the noteholders to seek an extension of the September 30, 2014 maturity date.  The email attributed the absence of any equity round to the company’s “growing revenue which has exceeded our projections”, as a result of which it “burned very little cash and [had] not needed to raise a qualifying financing”.  The absence of an equity round, however, meant it needed to extend the maturity of the note by 12 months to September 2015.  The requisite noteholders approved the maturity date extension, and later approved a second extension to March 31, 2016.

In February 2017 (i.e., following the March 31, 2016 maturity date), Vistar’s board approved the repayment of the Second Round Notes.  It also approved a new debt financing and the use of the proceeds of the debt financing to repurchase common stock through a tender offer.  In that same month, Vistar closed on a $20 million debt financing and launched the tender offer.

The following month, on March 16, 2017, Vistar notified the holders of the Second Round Notes of its intention to pay down the notes as required under their terms.  The Noteholders responded by contesting Vistar’s right to do so and expressed an expectation that the notes would convert to equity.  On or about March 30, 2017, Vistar nevertheless sent checks to the noteholders in repayment of the notes.  The noteholders rejected payment and returned the checks, claiming they had the right to hold the Second Round Notes until they converted into an equity financing.

The Noteholders’ Lawsuit and Vice Chancellor Glasscock’s Rulings

The noteholders commenced a lawsuit against Vistar in March 2019 in the Delaware Court of Chancery, seeking a declaratory judgment that they maintained a right to convert their notes beyond the maturity date, and brought alternative claims for breach of the implied covenant of good faith and fair dealing, promissory estoppel, equitable estoppel and reformation, arguing the Second Round Notes could not be unilaterally repaid by Vistar in 2017.  Vistar counterclaimed for breach of contract, alleging that the noteholders’ rejection of repayment was a breach of the Second Round Notes.

The noteholders then amended their complaint in 2022 after Vistar closed on a Series B round.  In their amended complaint, the noteholders alleged that the Series B round constituted a Qualified Financing and that the declaratory judgment they were seeking should state that the notes allowed them to convert into that Series B round.

The Court of Chancery issued two rulings.  On December 9, 2024, Vice Chancellor Glasscock ruled on the contract claims, finding that the notes required repayment without the holders having a right to convert, but reserved decision on whether principles of equity offered relief in light of Vistar’s post-issuance actions and statements. 

On January 17, 2025, Vice Chancellor Glasscock also ruled against the noteholders on their claims for equitable relief.

On the contract claims, Vice Chancellor Glassgock denied the parties’ cross motions for summary judgment because of the ambiguity associated with the operative language in the notes that principal and interest shall be “payable” on the earlier of the maturity date, sale of the company and an event of default.  The court ruled that Vistar’s interpretation that “payable” confined the noteholders’ rights at maturity to repayment, and the noteholders’ position that “payable” gave them an option other than to receive payment consistent with their business model, were each plausible.  The court then held a trial to decide the issue.

At trial, the noteholders argued that their removal of the option to convert or get paid at maturity (Vistar’s offer), in favor of mandatory payment, was due to a scrivener’s error and that they had the right to extend the term of the notes until a Qualified Financing. The court found the drafting history didn’t support this interpretation.  It further determined that the course of trade argument (i.e., that VCs’ and angels’ business model is to take equity in companies, not interest on debt) was not helpful here because the language was specifically negotiated by the parties and drafted by Valhalla.

Having disposed of the noteholders contract claims in the December 2024 opinion, Vice Chancellor Glasscock then addressed in the January 2025 decision whether equity offered the noteholders relief in light of Vistar’s actions post-issuance.  In this context, the noteholders argued that, during the post-issuance period, Vistar conveyed to the noteholders that an equity financing (triggering conversion) was imminent, on which the noteholders relied when they approved the two extensions requested by Vistar.  Presumably, the detriment to the noteholders was in keeping their capital in Vistar rather than redeploying it more profitably elsewhere.  As evidence of such implicit promise of an equity funding, the noteholders pointed to Vistar’s financial statements delivered to the noteholders which recorded the Second Round Notes as “purchase of stock”, as well as statements by Vistar to third parties that the notes were “basically an equity instrument”. But Vice Chancellor Glasscock determined it wasn’t reasonable for the noteholders to rely on Vistar’s accounting treatment of the notes, or on statements made by Vistar to third parties that the notes were “basically an equity instrument”, and so equitable principles would not justify imposing a contractual term that doesn’t exist. 

The noteholders also pointed to Vistar’s explanation to the noteholders at the time it sought the two extensions as to why an equity round had not already occurred (which would have triggered  conversion) – that it exceeded budget and had not needed to raise equity – but then as a result did need to extend the maturity date.  The noteholders argued that Vistar’s statements regarding its success and resulting lack of need for equity was an implicit promise that an equity round was coming upon which the noteholders relied in agreeing to extend the notes.  Vice Chancellor Glasscock didn’t buy it.  He attributed the extension request instead to a simple effort by Vistar to avoid paying down the notes, which it could do only if the maturity date was extended. The statements about success were insufficient to establish an implicit promise that an equity round was coming, and so the noteholders request for promissory estoppel was denied.

Key Takeaways

Investors in convertible note rounds don’t invest for the interest on their money.  Their business model involves taking equity in startups; they’re not banks.  Their expectation is that the notes will convert and the investors will benefit from the upside potential of the portfolio companies that succeed.  Investors need to be mindful of what the notes provide as to what happens at maturity.  They should negotiate for the option to convert or extend.  In the Vistar case, the noteholders lost out because the notes clearly provided that the notes were payable at maturity (assuming a sale of the company or event of default had not previously occurred, and assuming further that an equity financing had not occurred thereby triggering conversion), with no option to convert or extend.  The lesson for issuers is to be very careful not to promise that an equity funding would occur, and to try to negotiate for conversion upon maturity.