How a loan turns into equity: convertible loan in foreign jurisdictions

Elena Mashina

Convertible loan is a form of mezzanine investment. It allows a start-up to get funds quickly without having to go through a securities emission procedure. However, a startup may have a need to arrange a convertible loan outside of Russia. Although the concept is the same all over the world, there are certain peculiarities in some jurisdictions. In this article you can read about how to arrange a convertible loan in a foreign jurisdiction.

Contents:

What is a convertible loan?

A convertible loan implies that the investor first provides funds on the basis of a loan agreement and then, after the next investment round, acquires (or has the ability to demand) a stock or shares in the company. The convertible loan is used in both the early and late stages of a start-up. The advantage of this method is, on the one hand, the possibility for the start-up to obtain financing at an early stage when, firstly, it is difficult to value the company and, secondly, investors are cautious about providing equity investment in the company without return, and on the other hand exactly the possibility to reduce such investment risks by choosing a loan as a form of investment.

Regardless of the jurisdiction, there are two ways in which the convertible loan can be arranged:

Convertible Loan Agreement (CLA);
Convertible Notes.

In the first case, it is an agreement between the company and the lender; in the second case, it is a security. The fact that these instruments differ in nature means that the scope of application of these instruments also differs. Whereas a convertible loan agreement can be used to reduce the transaction costs associated with investing directly in capital, convertible bonds can hardly do so.

Treatment of convertible loans in different jurisdictions

In summarising foreign contractual practice in this area, three aspects need to be taken into account: existing contractual practice, the specifics of securities issuance regulation when issuing convertible bonds, and special forms (KISS, SAFE).

Understanding the contractual practices: what shall be written in the agreement?

A regular convertible loan requires the following conditions to be agreed:

Loan amount, interest rate, arrangement and repayment;
Serial or single maturity;
Maturity date: the period after which usually a new, larger round of investments starts, and conversion occurs, usually 12 to 24 months;
Form of conversion (e.g. conversion at maturity, call option, conversion by additional agreement)
Conversion settlement terms: here, conversion discount parameters are agreed (discount on share/stock price to current price (for risks taken at early stage)), valuation cap - maximum valuation threshold of the startup, based on which share/stock transfer obligations will be calculated, company valuation for compulsory conversion - Maturity Cap;
Pro rata rights: the investor's rights to maintain its participation interest in subsequent financing (conditions to avoid dilution of participation);
Change of control consequences;
Subordination Conditions: normally obligations under convertible loans have a lower priority than obligations under standard loan agreements;
Rights and Obligations of the Parties, Events of Default (Default Provisions);
Representations, warranties, covenants, etc.

Convertible Bonds in the context of Capital Market Regulation

Convertible bonds are still financial instruments and are therefore subject to all the registration and information disclosure requirements that apply to ordinary securities.

In the US, convertible notes may be offered as a registered offering or in a private placement pursuant to Rule 144A under the Securities Act of 1933. However, for "private" offer or closed subscription securities, there are significant restrictions on the negotiability of such securities.

Similarly, the applicability to convertible bonds is explicitly "highlighted" in Regulation (EU) 2017/1129 (Recital (10) and Article 2(b)).

Special forms

Two other forms of so-called seed financing are often encountered in practice: KISS and SAFE. However, both of these instruments are based on a conversion element, so they can be categorised as specific types of convertible loans.

SAFE (Simple Agreement For Future Equity) is a variation of a convertible loan agreement that gives the investor the right to receive an interest in the company upon the occurrence of certain events, such as a financing round (Next Equity Financing / Qualified Financing) or the sale of the company. Unlike a regular convertible loan, a SAFE has no 'maturity date' (until the conversion condition occurs, the SAFE remains in force) and no interest rate applied to the loan (investors only receive the right to convert their SAFE but not the usual lender rights under the loan agreement).

KISS convertible note (Keep-It-Simple-Security), is not as specific as SAFE: KISS terms usually set a borrowing rate (5%) and a "maturity" date (18 months), after which the investor can convert the investment amount (plus accrued interest) into an equity share. Some KISS also provide additional rights to major investors (e.g. informational rights) and include an MFN clause (the right to conditions no worse than those for investors attracted afterwards).

In this way, a KISS bond is more like a classic convertible loan, while a SAFE bond may never be converted at all. A KISS bond, however, has a binding maturity, and if the start-up fails to make the next round of investment by then, it remains a standard bond.

A convertible loan is one of the key financing instruments, especially in the early stages of a start-up. In Russian law, this institution is only finding its standards and practices of usage, while in the West it can already be considered established. A convertible loan is a convenient tool for both investors and start-ups. If you have any questions on convertible loans under foreign law, with a foreign element or based on foreign experience, contact the lawyers of A4 Legal Firm.