Convertible Note (Convertible Debenture)

A convertible note is debt from the day it is signed: the holder is a creditor, not a shareholder, until the note converts. Conversion usually happens in a priced equity round that meets the note's definition of a qualified financing, at a price below what the new investors pay.

In Canada it is often called a convertible debenture. The label changes nothing: Ontario's Business Corporations Act (OBCA) defines a debt obligation as a bond, debenture, note or other similar obligation, whether secured or unsecured, so read the repayment and security terms rather than the name. Under section 184 of the OBCA, unless the articles, by-laws or a unanimous shareholder agreement provide otherwise, the directors may issue debt obligations without shareholder approval, so a directors' resolution approving the notes is the usual starting point.

Our entry on the promissory note covers enforcement and limitation periods, and our guide to early-stage convertible financing in Canada covers what to confirm before signing.

Interest. State it as a yearly rate: under section 4 of the Interest Act, if a written contract sets interest for a period shorter than a year without an express statement of the yearly equivalent, no more than 5% a year is recoverable.

Maturity. The maturity date is when the note's debt character matters most. Unless the note says otherwise, an unconverted note is due on that date; common alternatives are an extension approved by holders of a majority of the principal or conversion at a pre-agreed valuation. Many early-stage companies cannot repay, so holders of a matured note gain leverage when the company is weakest.

Qualified financing. Automatic conversion usually requires an equity round raising at least a stated amount of new money, often excluding the converting notes; a smaller round may convert them only with the holders' consent. The conversion price is typically the lower of the discounted round price and the cap price. Our SAFE and convertible note modeler runs the numbers if you enter principal plus accrued interest as the converting amount, and pre-money vs. post-money valuation explains how the share count behind the cap changes the result. If the articles limit the number of authorized shares, section 27(3) of the OBCA requires the company to reserve enough shares to meet the conversion privileges.

Most early-stage notes are unsecured. In an insolvency, an unsecured noteholder ranks with the company's other unsecured creditors: behind secured lenders, ahead of shareholders. A secured note adds a general security agreement over the company's personal property. Under section 23 of Ontario's Personal Property Security Act, registration perfects a security interest in any type of collateral, so the investor registers a financing statement in the PPSA registry. A company with a bank facility should check whether its lender must consent.

Events of default usually include failure to pay at maturity, bankruptcy or insolvency proceedings, and breach of the note's covenants. On default the holder can typically accelerate the debt, charge default interest if the note provides for it, and sue for payment; a secured holder can also enforce against the collateral. Many notes let holders of a majority of the principal decide whether to accelerate or waive.

Since January 1, 2025, section 347 of the Criminal Code makes it an offence to enter into an agreement to receive interest above 35% a year, calculated as an annual percentage rate (APR) on the credit advanced. The old limit was 60% as an effective annual rate. The Criminal Interest Rate Regulations, SOR/2024-114, relax the limit for loans where the borrower is not a natural person and the borrowing is for a business or commercial purpose. A startup corporation issuing notes usually meets both, so the limit turns on the credit advanced:

The tiers apply to each agreement or arrangement, so a round made up of several $50,000 notes may sit in the 48% tier even if it totals more than $500,000. Under a transitional rule in the Budget Implementation Act, 2023, No. 1, interest received under a note signed before January 1, 2025 is not caught by the new rate if it was within the old limit.

The harder question is what counts as interest. Section 347 defines it as all charges and expenses, whether a fee, penalty, commission or in any other form, paid or payable for the advancing of credit, excluding repayment of the credit and a few listed items such as insurance charges. Whether the extra value a holder gets by converting at a discount or below a cap also counts depends on the terms, and the definition is broad enough that the risk cannot be assumed away. If it did count, a note converting six months after the advance at a 20% discount would deliver shares worth 125% of the converting amount, roughly 50% on a simple annualized basis before the coupon. Have counsel model the coupon, discount, cap, premiums and default interest together before signing.

A convertible note is a security. The Securities Act (Ontario) defines security to include a bond, debenture, note or other evidence of indebtedness, and any agreement providing that money received will be repaid or treated as a subscription to shares. Issuing notes therefore needs a prospectus exemption under the Act and National Instrument 45-106, usually the accredited investor exemption in section 73.3 of the Act or the private issuer exemption in section 73.4. Two details matter:

• The private issuer test excludes only non-convertible debt securities, so convertible noteholders, other than employees and former employees, count toward the limit of 50 beneficial owners.
• A report of exempt distribution on Form 45-106F1 is due within 10 days after a distribution under the accredited investor exemption or the family, friends and business associates exemption.

Conversion shares are exempt under section 2.42 of NI 45-106, which covers securities issued under the terms of a security already distributed, and need no new report.

Interest is taxable as it accrues, even if it is only ever paid in shares. Under subsection 12(4) of the Income Tax Act, an individual holder generally includes interest accrued to each anniversary of the note in income; under subsection 12(3), a corporate holder includes it as it accrues each year.

Leila Haddad and Tomasz Nowak run an Oakville medical-device startup with 9,000,000 shares on a fully diluted basis. In March 2025 the company issues four $100,000 unsecured convertible notes to four angels who qualify as accredited investors on the income test, each signing a Form 45-106F9. The notes carry 8% simple interest, a 24-month maturity, a 20% discount, a $6,000,000 valuation cap and a qualified financing threshold of $1,500,000 in new money. The company files Form 45-106F1 within 10 days. Each note advances $100,000 to a corporation for business purposes, so the 48% APR tier applies.

Eighteen months later, a seed fund invests $2,000,000 at $1.00 a share, a qualified financing. Each note has accrued $12,000 of interest, so $112,000 converts per holder. The cap price is about $0.667 ($6,000,000 divided by 9,000,000 shares) and the discount price is $0.80, so the cap governs and each holder receives 168,000 shares, 672,000 in total.

After closing, the company has 11,672,000 shares: the existing holders own 77.1%, the former noteholders 5.8% and the seed fund 17.1%. For tax, each holder must include the $8,000 accrued to the note's first anniversary in March 2026 in income for 2026, even though it was later paid in shares. Had the round slipped past March 2027, the company would have needed an extension or faced a $464,000 repayment claim.