Can a vendor take-back note convert into equity if I default?

A seller may propose a note that turns into ownership if the buyer cannot pay. That would be a contract term, not a default result. Whether it works depends on the note, the company’s articles and the statute that governs the company, so it needs to be drafted before closing. The rules below are the federal Act’s, which applies to federal corporations.

The statute recognizes conversion privileges

Section 29(3) of the Canada Business Corporations Act says that, where a corporation has granted privileges to convert any securities it issued into shares, and its articles limit the number of authorized shares, it shall reserve and continue to reserve sufficient authorized shares to meet the exercise of those privileges. Where the articles give shareholders a pre-emptive right, s.28(2) says they have no pre-emptive right in respect of shares issued under conversion privileges previously granted by the corporation. Ontario’s Business Corporations Act has a comparable reserve rule in s.27(3) for corporations formed under it.

Issue rules still apply

Section 25(1) makes the issue of shares subject to the articles, the by-laws, any unanimous shareholder agreement and s.28. Section 25(3) says a share shall not be issued until the consideration is fully paid in money, or in property or past services not less in value than the fair equivalent of the money the corporation would have received if the share had been issued for money. Ask counsel how cancelling debt is treated for that purpose, and read the guide to seller financing first.

What to ask before you agree

• Which events trigger conversion, and who decides the share price and how.
• Which class of shares the note converts into, and what rights they carry.
• Whether your lender allows a conversion feature.
• What the securities rules require for issuing the shares, and who confirms it.