What are they?
These are loans granted to companies that are structured so that, at certain pre-established milestones, the lender or borrower is empowered to decide to capitalise the loan, thereby receiving shares or equity in the borrower company. In other words, the Company does not repay the amount received through the loan and instead delivers shares or units that are issued in a future capital increase.
What are they used for?
Unlike typical loans, where what is sought is debt financing and whose amount will have to be repaid at maturity, convertible loans in a very high percentage of cases, and although it may seem contradictory, do not seek or are not intended for repayment and what they really “hide” is an investment in the equity of a company, i.e. in its shares or participations.
Convertible loans, I suppose with the aim of differentiating them from the traditional concept of a loan, are also known as convertible notes. Their use as a mechanism to enter to invest and participate in the capital of a company and not as a traditional loan or credit has had its boom in the Startup ecosystem where the company itself and the different investors (Business angels, Venture Capital funds, etc.) seek a quick and simple investment entry procedure that, in some way, as we will see, implies “certain security” for the latter.
How are they structured and documented?
It should be borne in mind that convertible notes involve, to a certain extent, the establishment of two legal transactions. On the one hand, we will have the loan in which the lender delivers an amount of money to the Company to be repaid within a term and plus interest; and on the other hand, the legal business whereby the amount delivered for that loan (plus interest if so agreed) is capitalised, terminating or extinguishing the loan contract and the lender will receive a series of participations or shares in the borrower Company, becoming a shareholder of the same.
Therefore, this type of investment or financing (depending on the point of view) is usually documented in a contract which, on the one hand, sets out the conditions relating to the loan and, on the other hand, those relating to the capital increase or “conversion” of the lender into a shareholder.
The Loan:
1.- The amount and disbursement of the loan will be essential elements, so the contract will have to establish the amount and the form and term of disbursement. Here the most particularities can be found when the exact amount and date of disbursement is not known at the time of signing the document and what is granted is a sort of “convertible line of credit” which the company will draw on. This is not very common, but it does not present any major challenges other than the need to dedicate a series of clauses to establish a maximum amount, the form of drawdown, terms, etc.
2.- The parties will have to establish whether they want the loan to accrue interest and whether this interest will be fixed, variable or a combination of both. Interest can only be demanded if it is stated in writing, as established in article 314 of the Spanish Commercial Code, hence the importance of this being reflected in the text of the contract.
On many occasions, “a variable interest rate is established which will be determined according to the evolution of the borrower company’s activity”, which makes the convertible loan also participative, in accordance with the provisions of Article 20 of Royal Decree-Law 7/1996, of 7 June, on Urgent Measures of a fiscal nature and for the promotion and liberalisation of economic activity. The fact that the loan is also participative is not a trivial issue and, as we shall see, has legal and financial consequences.
3.- In the case of convertible notes intended to provide entry to investors in start-ups or entrepreneurial projects, it makes a lot of sense for the investor or lender to want the loan to be used for specific activities or investments leading to the growth of the project, as well as for the Company to assume certain obligations such as reporting, compliance with the business plan, no cash outflows for certain amounts, etc.
4.- Although the final intention of the parties is to capitalise the loan, we must not forget that we will have to regulate in the contract both the maturity and the early repayment of the loan. Let’s think, for example, that the loan is destined to a matter that has nothing to do with the project, or that the management team in which the investor really trusts, leaves the company. Obviously, these are very relevant issues and, logically, they will lead to an early repayment of the loan, and the investor will therefore be able to demand repayment of the loan plus the agreed interest, if applicable.
5.- From the Company’s point of view, and as in “traditional” investment rounds, it is important to know and select the investor. The degree of conflict of some of them, their reputation, interest in the project, etc., are some of the reasons why a project may decide not to allow an investor to enter. In this sense, it is highly advisable to establish limits or require the authorisation of the company for the assignment of the loan by the investor.
The conversion of the lender into a partner:
1.- Any loan, credit or debt that the company has, provided that it meets certain requirements, may be compensated by means of a capital increase. However, it is the convertible notes that regulate such capitalisation from the outset in the text of the contract.
2.- The capitalisation of the loan will be carried out through a Capital Increase by offsetting credits, a procedure regulated in Spain in article 301 of the Capital Companies Act.
3.- It will be necessary to establish in what situations, when and by whom the capitalisation may be activated and when the loan will be liquid, due and payable (essential requirements for capitalisation). In practice, there are as many convertible notes as there are projects, so it is common to find contracts in which the power to capitalise falls to the investor and others in which it is the company that decides whether or not to capitalise. In principle, the autonomy of the will of the parties prevails, establishing the regulation that they consider, although, as we will discuss, problems of execution may arise.
4.- To carry out the capital increase with guarantees for both the investor and the Company, the economic valuation of the Company, also known as the pre-money valuation, must be established. The purpose of this figure is as important as determining how many holdings or shares, and therefore what percentage of the share capital, the investor will receive after the capital increase. Sometimes, in order to receive the funds or convertible loans quickly, the company offers a discount on the pre-money valuation, which results in the lender or investor obtaining a higher percentage of the capital.
5.- Let us not forget that the convertible notes in most cases materialise a round of financing, so in addition to the particularities mentioned above, it will be necessary to carry out those specific to the convertible notes and to subscribe, almost as one and the same act with the convertible note, the corresponding shareholders’ agreement. This shareholders’ agreement, also known as “SHA”, is an agreement or contract entered into by all or some of the shareholders, the company itself or even third parties to regulate certain matters of the company’s operation which, for various reasons, either do not have a legal place in the Articles of Association or are preferred to be reserved between them. In this type of operation, the role of shareholders’ agreements is crucial as they regulate, among others, aspects such as:
- Implementation of the Investment Round.
- Anti-dilution clauses for shareholders (preferential subscription rights, issue premiums, reinforcement of majorities, etc.).
- Transfer of shares/shares and exit agreements (dragging and tag-along rights).
- Functioning of the Company’s bodies (attendance and/or voting quorums for certain resolutions, election of members of the administrative body, etc.).
- Members’ right to information.
- Confidentiality, exclusivity, non-competition and permanence clauses for certain partners.
- Profit sharing.
- Termination and resolution of deadlocked situations.
As we can see, when we are faced with an investment round articulated via convertible loans, we will have to pay attention to the duality that the contract we sign will present. On the one hand, it will have to regulate the part relating to the loan and, on the other, the part relating to the consideration of convertible and its application. Furthermore, in order to protect the position of the investors or the Company, it is highly recommended that all the partners, investors and the Company itself sign a shareholders’ agreement that allows the convertible note to be executed and regulates its future operation.
Advantages, disadvantages and issues to consider
There are clear advantages to materialising an investment round using convertible notes, but there are also certain disadvantages that are often unknown and can be quite significant.
Advantages:
1.- The main advantage is that it allows the investment to quickly enter the Company’s cash and its use, while the necessary actions are being carried out to agree on the capital increase (call, report from the administrative body, General Meeting, etc.).
2.- Depending on how it is structured, it can provide the investor with greater security as it allows him to obtain repayment of the loan if, after the established period, he considers that the investment is not entirely worthwhile.
In projects that are at an early stage, it is extremely useful because a relatively long term can be agreed upon, allowing the lender to see the evolution of the project without risking the “investment” and also allowing the company to have access to funds without the need for the partners to be diluted.
Disadvantages:
1.- If nothing has been agreed in this respect, this may be detrimental to existing minority shareholders in the company, as they do not have a pre-emptive subscription right in capital increases by offsetting credits. It is article 304 of the Capital Companies Act which establishes this, providing shareholders with such a right only in capital increases by monetary contributions. Not having this right automatically implies the dilution of the shareholders, so this type of increase can be used “fraudulently” to escape the procedure of increase by cash contributions and, therefore, force the dilution of the remaining shareholders.
2.- If the shareholders’ agreement is not properly tied up, we may find ourselves faced with the paradox of having a convertible loan signed but which it is not possible to capitalise. The convertible notes are signed by the Administrator or Administrators on behalf of the Company as the borrower, i.e. the Company assumes the obligations to repay the loan and some other minor obligations, but the Company cannot, although this is incorrectly done, be obliged to increase the capital and therefore capitalise a loan. The General Meeting of Shareholders is the only body that can approve a capital increase by the majorities established in the Law, Articles of Association or shareholders’ agreements, but it will always require the action of the shareholders. The best solution is for all shareholders, in addition to the company, to be a party to the shareholders’ agreement that is signed and attached to the convertible note so that, when the time comes and in the event that they do not carry out the capitalisation, they can request compliance with the shareholders’ agreement and the capital increase. The enforcement of shareholders’ agreements is not a simple matter and, to some extent, there is apparently contradictory case law. Without going into it, what is clear is that if the shareholders are not signatories to the convertible note or the shareholders’ agreement in which it is regulated, no liability can be demanded from them in this context.
Issues to be assessed:
1.- When an interest-bearing loan is granted, a very relevant issue is taxation. As a general rule (it will be necessary to analyse where the lender resides, whether there is a double taxation avoidance agreement, etc.), the corresponding withholding tax will have to be applied to the interest. It is logical that the convertible note is designed in such a way that there are no periodic interest payments and that the amount of the loan and interest are capitalised in full. However, from a tax point of view, it will be necessary to analyse with an expert whether the wording of the note can be understood that the obligation to withhold arises at a time prior to the end of the loan, which will obviously have an effect both for the Company (it will receive less funds) and for the investor (it will be taxed and will receive a lower percentage).
2.- Also related to taxation, it should be considered that if the investor or lender is already a partner or related party of the Company and although commercially we can establish the interests we consider, fiscally it may be considered a related-party transaction and should be valued at market price.
3.- As mentioned above, it is common to find convertible notes that are also participating loans. It is important to know that these will be considered the company’s equity for commercial purposes, which will have consequences when it comes to assessing whether the company is subject to dissolution or mandatory capital reduction, articles 363.1.e and 327, respectively, of the Capital Companies Act.
4.- In the event of possible insolvency of the Company, both the participating loans and those granted by “persons especially related” to the insolvent party will be considered as subordinated credits, and this is in accordance with article 281 of our Insolvency Law.
5.- At the accounting level, there have recently been modifications by the International Accounting Standards Board that affect convertible debt, which may have to be accounted for as current debt.
Conclusions
The use of convertible notes to carry out an investment round is widespread in practice and, fortunately, in most cases the process is completed without major difficulties and avoiding many of the issues we have discussed. However, in my opinion, when planning an investment round through convertible notes, a detailed analysis of all the tax, accounting and future execution implications must be carried out, as what is perfectly suited to one start-up may not necessarily be suitable for another, and the consequences may be significant.
