The convertible loan - VC investments in the light of COVID-19

Austria
Available languages: DE

The contemporary COVID-19 pandemic poses significant challenges to small and medium-sized enterprises (SMEs), especially start-ups. The procurement and maintenance of liquidity is the order of the day. To secure the growth and development of Austrian SMEs and start-ups in the long term, it is, apart from existing and planned emergency measures by the government, also important that (regular) financing rounds and investments continue to take place as planned.

While a reliable valuation of young companies and start-ups for (early-stage) financing rounds has been difficult in the past, the uncertain economic situation makes this increasingly true for more established companies. As the pandemic progresses, financial figures derived from the latest annual accounts and the performance of the company prior to the COVID-19 crisis seem to lose more and more relevance. However, a solution might already be available: With the convertible loan (Wandeldarlehen), originally stemming from the Anglo-American sphere and increasingly established also in Europe, it is possible to provide the company with liquidity straight away and convert the investment into a direct equity participation at a later point in time, for example within the framework of a capital increase after the current crisis has abated. The question of the (concrete) valuation is thereby postponed.

Against this background, it is worth taking a closer look at the convertible loan. The following overview offers a first orientation.

Structure and process

Initially, a convertible loan is debt capital for the company. The investor grants the company (e.g. a private limited liability company, GmbH) a loan; usually for a certain term and subject to interest (recurring or final). The special feature of a convertible loan is that the investor can or must, under certain predefined conditions, convert the loan amount into a direct equity participation in the company. If the loan is not converted, it must be repaid at the end of the agreed term.

The procedure for and the conditions of the conversion mainly depend on the agreement between the parties (the investor, the company, and the shareholders) and can be arranged in a rather flexible manner. The conversion is usually carried out within the framework of an (ordinary) capital increase. The investor acquires a newly issued share quota in the company against payment of the nominal amount. The premium on the subscribed share quota is then paid by the investor with a waiver of the loan repayment. The extent of the share participation is determined on the basis of (pre-)agreed valuation criteria and the amount of the loan (including interest) at the time of the conversion.

Common practice distinguishes between the right and the obligation to convert the convertible loan. The conversion right grants the investor the right to demand a conversion into a share quota in the company; in the case of a conversion obligation, the investor must convert the convertible loan accordingly. Experience shows that convertible loan agreements often include (graduated) combinations of the conversion right and obligation. The agreement of certain periods, dates or deadlines on which the conversion can or must take place enables planning security. Furthermore, a conversion right or obligation can also be made dependent on the occurrence of certain predefined events, so-called trigger events. Trigger events could, for instance, be the achievement of certain financial ratios by the company, an exit by the founders or, frequently in practice, the implementation of a (qualified) financing round with additional investors.

Agreements pertaining to the transfer of share quotas or the subscription of new share quotas in a private limited liability company (GmbH), including convertible loans, are subject to formal requirements and must be concluded in the form of a notarial deed. In the light of the COVID-19 pandemic, reference should be made to recent facilitations with regard to the conclusion of notarial deeds by electronic means.

Extent of conversion/evaluation

The conversion can be seen as the central element of the convertible loan. Long-term strategic considerations are particularly important given the extent of the share quota to be acquired in the course of the conversion and the fact that the conversion ultimately leads to the investor being included in the circle of shareholders as a long-term partner and thus gaining direct influence over the company and its management.

The enterprise value on which the conversion of the convertible loan is normally based is often predetermined upon the occurrence of a trigger event, for example, in of the course of an upcoming financing round or an exit. If the convertible loan is to be converted independently of a trigger event, the valuation can be negotiated by mutual agreement between the parties. If such agreement cannot be reached, the parties may also seek a (binding) expert opinion to determine the valuation for the purpose of the conversion.

The company valuation underlying the conversion is often defined to remain within a certain range. A maximum valuation is agreed by means of a so-called "cap". A "floor" refers to a minimum valuation agreed by the parties. A "discount" grants the investor a percentage discount, for example as a risk compensation component. In this case, the lender receives the share quota in the company on a more favourable basis than the actual valuation.

Co-determination and rights of influence

Upon conclusion of the convertible loan agreement, the investor is usually granted certain contractual inspection and information rights. These enable the investor to observe the further development of the company and to take precautions regarding the potential conversion of the convertible loan. In any individual case, the investor may also be granted further rights, such as rights of approval for management measures.

By issuing the convertible loan, the investor does not become a shareholder and is first and foremost a creditor of the company. Due to the conversion option, however, the investor will be included in the circle of shareholders in the near future and will then also receive corresponding shareholder rights. Experience shows that it is, therefore, essential that the parties consider the nature of their future cooperation already when negotiating the convertible loan agreement.

The future legal relationship between the shareholders, such as rights of approval and participation, information rights or rights concerning the shares (e.g. transfer restrictions or mutual pre-emption rights) should be agreed upon, at least in principle, in the convertible loan agreement. If the conversion takes place within the framework of an upcoming financing round, these issues could also be linked to the result of the negotiations of that financing round. In this case, the investor of the convertible loan would be bound to the same rights and obligations as the other investors participating in the financing round. It should be noted that concessions made to the investor within the convertible loan may have a prejudicial effect on financing rounds and later investors will generally demand at least equivalent rights - a strategic balancing act that must be carefully weighed up.

Insolvency risk

Until conversion, the convertible loan is considered debt capital. Naturally, a convertible loan involves risks not only for the company but also for the investor. In relation to third-party creditors, the convertible loan agreement usually contains a co-called qualified subordination clause (qualifizierte Nachrangigkeitsklausel). In the opinion of the Austrian Financial Markets Authority (FMA), granting a loan with qualified subordination does not (usually) constitute an activity requiring a banking licence. Moreover, if the loan is granted with qualified subordination, it will not be considered when determining the ‘calculated over-indebtedness’ (rechnerische Überschuldung) of the company. In the event insolvency proceedings are initiated, third-party creditors thus take precedence and there is a high risk that the convertible loan will be lost.

Conclusion

In summary, a convertible loan offers a potential opportunity to bridge financing rounds postponed due to the current COVID-19 crisis and to provide companies with urgently needed liquidity and investor support. Some essential differences to an (immediate) direct equity participation can be summarised as follows:

Advantages for investors Disadvantages for investors
  • Flexible design and feasibility
  • Postponement of the (concrete) valuation possible
  • Repayment of the convertible loan may be possible
  • Interest rate and, if applicable, risk compensation
  • No direct shareholder position (until conversion)
  • Limited rights of influence and control (until conversion)
  • Uncertain development of the valuation
  • High risk (subordination)
  • Formal requirements (notarial deed)
 Advantages for the company  Disadvantages for the company
  • Flexible design and feasibility
  • Postponement of the (concrete) valuation possible
  • Use as bridge financing and for the purpose of obtaining rapid liquidity
  • Not considered for the assessment of the calculated over-indebtedness (subordination)
  • No direct involvement of the investor (until conversion)
  • Interest rate and, if applicable, risk compensation
  • Uncertain development of the valuation
  • Determination of shareholder rights in principle already required in advance and decisive for future financing rounds
  • Formal requirements (notarial deed)

Despite the extensive freedom of design of the convertible loan agreement, it is essential to weigh up the advantages and disadvantages and plan and coordinate carefully!