The convertible loan is a versatile financing instrument.
There are circumstances when it makes sense for equity investors to consider the option of a convertible loan, at least as an interim measure. Similarly there are circumstances when debt financiers should consider seeking the potential upside of an equity conversion right, possibly to bridge a gap in expectations between the lender and the borrower over debt terms.
In many respects the convertible loan offers the best of both worlds for the financier- the priority of debt, but with all or some of the upside of equity (depending on the equity conversion formula).
While that may sound like a good deal for the financier at the expense of the recipient, this is not necessarily the case. There are circumstances when a convertible loan makes sense for both sides and it may be the only form of financing which is viable in some cases.
This article considers the circumstances when a convertible loan structure may be the best or most viable financing option and some associated key deal issues which should be considered.
KEY ATTRIBUTES OF THE CONVERTIBLE LOAN
The convertible loan is a debt instrument until it is converted. However, as noted in the introduction, it has the potential upside of equity (depending to some extent on the conversion mechanism described later in this article).
While the convertible loan is a debt instrument, it often carries risk which is more akin to equity risk. That is because it is typically used in circumstances when conventional debt is not available to the borrowing company or is not available on reasonable terms, because of the risk profile. The convertible loan has priority over the equity, but that priority is academic if the company has no realisable assets to repay debt or return equity.
The terms of the convertible loan will also determine the extent to which the loan is closer to equity than conventional debt. Some of those terms are discussed in this article.
WHEN MIGHT A CONVERTIBLE LOAN BE PREFERRED TO AN EQUITY INVESTMENT?
The convertible loan option should be considered when an equity investor is not yet ready to commit to a long term equity investment in a company for whatever reason, but the company needs, and the equity investor is prepared to provide, finance in the meantime (normally for seed purposes or for growth). Typical circumstances which might create this situation include:
- The company or potential business idea is at a formative stage. Preliminary funding is required for a pilot study or to finance activities required to achieve a particular milestone which will indicate whether the business has sufficient potential to justify a more significant longer term investment.
- The equity investor is providing growth funding in anticipation of an IPO or other liquidity event, but has no interest or mandate to be locked into an illiquid private company investment long term (i.e. if the liquidity event is not achieved).
- The equity investor needs more time to complete full due diligence but the company needs preliminary funding in the meantime.
If the funder is not ready to commit to an equity position for any of these reasons, the convertible loan is probably the only tenable option. Potential alternatives like an equity investment where the investor has a put option to require the company or other shareholders to buy back the shares are more complicated and problematic for a variety of reasons. By comparison the convertible loan is simple and clean and provides stronger exit rights for the funder.
WHEN MIGHT A CONVERTIBLE LOAN BE PREFERRED TO CONVENTIONAL DEBT?
A convertible loan may also make sense for funding which is of a mezzanine nature or is otherwise for growth, where the risk of default is high, but this is matched by a corresponding opportunity for the borrowing company to achieve significant growth and value appreciation.
In those circumstances an interest rate which fully reflects the lender risk may be exorbitant and unaffordable for the borrowing company. However the lender may be prepared to accept a lower interest rate if it has an equity conversion right which might provide a ‘super return’ if the risk pays off (i.e. potentially a higher return than the exorbitant interest rate which might apply for conventional debt which has no equity upside).
SOME KEY CONSIDERATIONS FOR THE BORROWER
A key consideration for a borrowing company, particularly a borrowing company which is really seeking an investor prepared to take equity risk, is that a convertible loan is debt, not equity (unless and until such time as it is converted). This distinguishes a convertible loan from preferred equity.
That means that the company has a legal obligation to pay back the loan if it is not converted by the lender. Further, the decision whether to convert or seek repayment is usually at the lender’s sole discretion (see below) and repayment is more likely to be required if the company has not progressed as hoped, which is when the company may have diminished capacity to repay a debt.
Where the borrowing company is concerned about its ability to repay the loan (if required to do so), it should seek a reasonable time window from receipt of a notice from the funder (that the funder is not converting to equity and requires repayment) in which to effect that repayment (before any lender enforcement rights or penal provisions of the convertible loan agreement can be applied).
The directors of a company which is accepting a convertible loan in full knowledge that there is a high risk that the company will not be able to repay the loan may also be concerned about potential personal liability. In these circumstances the company may require the convertible loan to expressly limit recourse to net cash available from the realisation of assets and to provide for forgiveness or conversion of any residual debt which cannot be repaid from those available assets.
Another key consideration for the borrowing company is that a convertible loan may block other capital raising opportunities while it remains in existence. The company should ensure that it can trigger a requirement for the lender to either convert or accept repayment at any time after an agreed date (before the loan hampers other capital raising activities).
Where the funder is not yet ready to commit to a long term equity investment and requires an exit right, the company may actually share the funder’s preference for a convertible loan rather than equity. This avoids the company restructuring its equity and implementing any associated shareholder rights (which may include the introduction of preferential equity rights) on what could be just an interim basis. It also avoids dealing with more complex exit rights. For example, a right for the funder to put shares back to the company would require the company to effect a share repurchase from one shareholder (rather than all shareholders pro rata), which is regulated by the Companies Act and potentially requires a disclosure document (unless all shareholders consent) in addition to director certifications, etc.
The convertible loan will be closest to equity if the conversion price is fixed at the time the convertible loan is made, based on the market value of shares at that time. In that case, the convertible loan captures the capital upside of equity.
At the other end of the spectrum is a right to convert at a market price to be determined at the time of conversion. Under this scenario the convertible loan does not capture equity upside while the loan is in existence and the conversion right has limited (if any) value. Accordingly the convertible loan in this case is closest to conventional debt, with negligible set-off between debt terms and the conversion right.
There are other conversion price mechanisms which are somewhere in the middle of the range described above, such as:
- a conversion price which is still fixed up front, but includes a premium over the market value at the time the loan is made;
- a conversion price determined at the time of conversion which is equivalent to the price at which company shares were last issued before conversion;
- a conversion price which is fixed up front, but reflects the anticipated value of shares if certain milestones are met (being the milestones, such as a successful pilot study, which must be achieved before the lender is prepared to commit to an equity investment).
INTERACTION BETWEEN CONVERSION PRICE AND INTEREST RATE
Logically, the interest rate and conversion price should be considered together.
Arguably there should be no interest during the conversion period if the conversion price is the value of shares at the time the loan is made, otherwise the lender is ‘double-dipping’ to some extent.
However it is not that simple for a seed investment, where typically a mezzanine level interest rate in the region of 15% will also apply, even though the loan is a substitute for equity and the conversion price is fixed up front. The justification for that is that the conversion price is largely contingent on the milestones being achieved (i.e. the lender doesn’t put any value on the shares and is not prepared to commit equity until then). In the meantime it is the lender’s convertible loan which is funding the milestones and proving value, so the lender should be compensated for the time value of money until the milestones are achieved.
The situation is different for a company which is further down the growth path, has already attracted investment capital and where the conversion price reflects current value, before achievement of any equity conversion pre-conditions like IPO readiness (which would increase that current value). In that case there is a strong argument that interest should only apply if the conversion conditions are not met in the expected timeframe and the lender elects not to convert (and then only from that point in time). Alternatively, the interest rate should be discounted to reflect that the lender will also capture all of the upside of equity.
If the conversion price is the market price at the time of conversion then there is no reason why the interest rate should be reduced to reflect the value of the conversion right. If the conversion price is somewhere in the middle, then there might be some offset but a market based interest rate is still likely to apply.
Where the convertible loan is in the nature of seed capital, it is common for the time value of money calculation to be incorporated in the conversion formula for tax reasons (in an attempt to avoid taxable interest being derived on what is still a high risk seed stage investment), rather than being reflected as ‘interest’. Actual ‘interest’ is then only payable if the loan is not converted, (and then only if demanded by the lender).
SHOULD CONVERSION BE ENTIRELY AT THE LENDER’S DISCRETION?
Conversion is usually at the sole discretion of the lender.
While the company may wish to define conversion conditions and achieve more certainty that the loan will be converted to equity if it achieves measurable targets, that is generally impractical in reality. Normally the lender will want discretionary general conditions in addition to any specific and measurable conditions like revenue or profit targets, so it can take account of all relevant factors at the time of making its conversion decision. Otherwise specific measurable conditions might be manipulated or might not reflect the full picture. Once lender discretion is introduced, there is limited value in trying to limit that discretion by drafting explicit conversion conditions.
SHOULD THE LOAN BE SECURED?
As a convertible loan is debt, there is an opportunity to secure that debt, normally by a general security over the company’s assets and undertaking.
Even if the borrowing company has no tangible assets which have security value, there are still good reasons why the convertible loan lender will take security. They include:
- a security will give provide notice to other parties dealing with the company that the loan exists (otherwise there will be no public record of the loan);
- a security will prevent any other lender from gaining priority over the convertible loan (otherwise, even though this will usually be prohibited under the terms of the convertible loan, a subsequent lender might still gain priority by registering a security);
- a security will significantly increase the lender’s leverage to achieve whatever exit might be available and allow the lender to take control of that process if necessary (through receivership provisions etc.).
DO SHAREHOLDER RIGHTS WHICH WILL APPLY FOLLOWING CONVERSION NEED TO BE AGREED UP FRONT?
Unless any shareholder rights which will apply on conversion are agreed up front, the lender will only have leverage to require such rights later if the company wants the lender to exercise the conversion right at that time. However if the company has made good progress during the convertible loan term and consequently has other equity or debt funding options which are more attractive than the previously negotiated conversion price, the lender may have little or no leverage when it comes to conversion. In that case it will only be entitled to those rights specifically agreed up front (which it is contractually entitled to) or which already attach to the class of equity issued on loan conversion.
It is often a dilemma just how far the parties go in spelling out all of the detail of the shareholder rights which will apply if the loan is converted. One of the attractions of the convertible loan is its relative simplicity and the fact that it can be agreed between the company and lender without necessarily involving other shareholders.
Often a pragmatic approach is taken of agreeing any fundamental rights up front (in sufficient detail to ensure that the lender will at least get the core elements of those rights) and specifying a process to resolve other detail at conversion time. While this may not offer perfect protection for the lender, it may be an acceptable base position (noting it should still have some further leverage at conversion time unless it is demonstrably ‘in the money’ at that time – in which case the base position should be acceptable).
The convertible loan is a versatile financing instrument and has particular application when an equity investor is not yet ready to commit to a long term equity investment in a company for whatever reason, but the company needs finance in the meantime (normally of a seed nature or for growth).
The convertible loan potentially offers the best of both worlds to the lender, debt priority and protection, but with equity upside. A key benefit for both parties is that it is relatively simple to put in place, although this will be influenced to some extent by the approach taken in respect of future shareholder rights which will apply on conversion.
The borrowing company needs to be aware that a convertible loan is debt, not equity. If it is not converted by the lender, there will be a legal obligation to repay the loan. Conversion will usually be at the sole discretion of the lender.
There is a trade-off between the conversion price (or associated mechanism) and the interest terms on the loan. The borrowing company should resist the lender ‘double dipping’ by capturing a market interest return plus all of the equity upside.
Because the convertible loan is a debt, it can be secured. Even if the borrowing company has no realisable tangible assets, there are some clear benefits to the lender (in terms of additional protections) if it takes security.
Andrew Lewis Law