How Loan Turns into Investment: Convertible Loan in Russian Law

There are a number of ways to raise financing for a start-up. One of them is a convertible loan. This instrument allows the start-up to get money quickly, which will later be converted into shares belonnging to lender. When implementing this concept, you need to consider corporate law provisions, exactly what the corporate structure will look like, in which cases the loan will be repaid, and how to describe the terms of the loan. You can read more about how to draft such agreements in this article.

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Nature of the convertible loan

In a convertible loan, the funds lent by investors to a start-up can be converted into a share in the share capital of the LLC or into equity in the joint-stock company. In this way, the lender becomes a shareholder or stockholder in the company.

This type of financing is possible at both early and late stages. Compared to venture capital loans, convertible loans have a lower interest rate, which makes them more attractive for businesses. The main concern of the lender under this model might be to acquire a share in the company in the future.

What to consider when drawing up a convertible loan

Matters relating to loans in convertible loans

The first stage and heart of a convertible loan is the granting of the loan itself. In this regard, the following terms are required to be agreed upon:

Loan amount
Loan term
Interest rate.

Conversion process for convertible loan

The first thing to decide is under what circumstances the conversion will take place. It is possible that conversion will not be initiated and then the loan will have to be repaid. Typically, in foreign experience, conversion takes place after the next investment round, but there are actually no restrictions or limitations. It needs to determine who can initiate the conversion: the investor or the founders. It is also important to keep in mind the ambiguous practice of forced conversion in foreign law, so in Russian law such a process may also raise questions.

If conversion does not take place, the consequences should be covered:

Repayment of borrowed funds
Prolongation of the agreement.

The next mandatory element is the discount to be granted to the investor. The discount is the difference by which the lender's share price for the converted loan is reduced. If the discount is 10%, the lender who made the loan will buy at 0.9X, even though all other investors will buy at X price. The discount is an incentive to lend early. With their discount, they will be able to get more shares when they convert.

The third point to discuss is the valuation cap. This is the maximum value at which the startup can be valued at the moment of conversion. Even if the project might actually be valued much higher, the calculation of the lender-investor's share will be based on the cap determined. It is thus an opportunity for the investor to secure a certain amount of stake and corporate power in the future.

Corporate matters on a convertible loan

All corporate issues basically come down to the choice of corporate structure. What corporate rights will the creditor have after conversion? This depends on the type of shares: ordinary or preference shares. The latter do not give voting rights, as a general rule, but provide certain guarantees when dividends are paid.

A convertible loan is flexible enough that many of the terms and conditions can be set by the participants themselves. Nevertheless, potential risks must be foreseen and mitigated through the use of corporate structuring: e.g. options with existing participants, the prior conclusion of a shareholders agreement, etc. The Civil Code provides for the possibility of concluding a corporate agreement not only between the participants, but also involving third parties. Consequently, even at the stage of entering into a convertible loan, when the lender is not yet a participant, it is already possible to enter into a agreement and provide certain guarantees to the lender.

Legal structuring of convertible loan under Russian law

Convertible bonds. The company issues securities, namely bonds, which may then be converted into shares. The most obvious disadvantage of this method is the inability to apply this model to LLCs.
Convertible loan agreement

New convertible loan regulation in Russia

On 13 July 2021, the Federal Law came into force, amending the Russian corporate regulation to create a legal framework for the institute of convertible loan in Russia. The Law establishes the procedure for the implementation of conversion in LLCs and JSCs, certain restrictions on borrowers (for example, Russian PJSCs cannot act as borrowers in convertible loans) and general conditions of the agreement (the general meeting approval, notarial form, entry of information in the Unified State Register of Legal Entities). One of the key provisions is the possibility to set deadlines that are binding for the parties. A breach of time limits will result in the possibility of enforcement, which, however, based on a literal interpretation of the law is only possible through commercial courts (excluding the possibility of arbitration).

The convertible loan is one of the most convenient investment instruments. While various options for structuring convertible loan relationships were available in the past, the practice today needs to develop the regulation that has been introduced. If you have any questions regarding convertible loans to attract investment to your start-up, contact the lawyers of A4 Law Firm.