In the dynamic landscape of start-up financing, innovative solutions are constantly sought to fuel growth and development. One such instrument is the convertible loan. A convertible loan enables a debt to be converted into an equity stake, allowing funds to be provided to the start-up company quickly and then converted at the appropriate time, under predefined conditions, typically triggered by a future financing round or specific milestones.
In essence, a convertible loan offers flexibility and a potential upside for both parties involved. Because of the flexibility and ample room for maneuver conferred to the parties, convertible loans can be a good way for young companies to find financing, especially at an early stage of their activity. This insight aims to give an overview of the principal characteristics, advantages and disadvantages of convertible loan agreements.
1 UNDERSTANDING CONVERTIBLE LOANS
A convertible loan is a variant of the traditional loan, governed by art. 312 ff CO (dispositions which are in principle applicable)[1]. In addition to requesting the classic reimbursement of the amount loaned, plus interests, the convertible loan enables a debt to be converted into an equity stake. This allows the investor, not to immediately convert his investment into equity, and/or to make such conversion conditional on the achievement of certain objectives or milestones[2]. This can be particularly interesting when investing in innovative start-ups whose development and success are uncertain.
From a practical perspective, the lender receives a call option, which is offset[3] against its claim to repayment of the capital made available[4]. This means that the lender does not have to invest any new funds to participate in the company's capital .In accounting terms, the release of shares in the event of conversion of the loan into capital results in a reduction in the company's liabilities and an increase in shareholders' equity (capital)[5].
The codification of the conversion of a debt in the Swiss Code of Obligations is relatively simple, giving the parties considerable leeway to organise and execute it in accordance with their needs In this respect, it is important to emphasize the importance of clearly regulating the process through a contract between the parties (the company and the lender). Amongst the few dispositions relating to the offset of a debt, it is worth mentioning art. 634a CO relating to the payment of contributions through offset with a claim[6]. Moreover, art. 653 para. 1CO on conditional capital increases refers to the right to acquire new shares by conversion or option.
From a civil law perspective, there are no limits whatsoever as to who may enter into a convertible loan agreement[7]. However, careful attention should be given when the lender is (i) already a shareholder of the company[8] or (ii) when a group of investors invest either as a “pool” or through several individual agreements within the same transaction[9].
2 key Elements To Be Agreed Between The Parties
· Determination of the price and quantity of shares received upon conversion.
The price per share may correspond to the nominal value of the shares or be based on the valuation of the company at a specific time, as agreed upon by the parties. The parties may agree that the lender benefits from a “discount” because of his early commitment to the company[10].
The quantity of shares, representing the percentage of the share capital, will be determined based on the amount of the converted debt proportionally to the valuation of the company agreed upon by the parties[11].
· Whether conversion is mandatory or optional.
· Trigger event for the right or obligation of conversion, or conversion period of the loan following the occurrence of the trigger event.
This refers to a specific event or a timeframe within which the lender must exercise their conversion right to avoid forfeiting it[12].Alternatively, parties may choose not to specify a trigger event, granting the lender the flexibility to exercise their right at their discretion. Less frequent, but still possible, is the unilateral option for the company to decide to repay the loan[13].
· The parties may contractually agree on other terms and conversion rates, including tying them to the progress of the company or conditioning the loan conversion on larger investments from the investor[14].
3 Pros and Cons
Due to the flexibility of the instrument, financing through convertible loan is ideal for companies in the early stage of development, bringing benefits to all parties involved. However, potential parties to a convertible loan agreement, should also take into consideration the possible disadvantages of this method of financing, and mitigate them via negotiations and a carefully drafted agreement .[15]
For the Company/Founding Shareholders
Advantages:
- Flexibility in financing without immediate valuation negotiations.
- Preservation of ownership for founders.
- Simplified administrative complexities.
- Rapid provision of liquidity.
- Reduction of liabilities and increase in shareholders' equity upon conversion.
- Considerable leeway for effective organization and execution of debt conversion.
- Possibility of capital injection to regain control and stabilize the company in case of financial distress.
Disadvantages:
- As is typical for debt institutions, the borrower (i.e., the company) has to pay interest to the lender.
- The lender will most likely demand that collaterals are put in place, documentation be prepared and information disclosed – the last can be quite “dangerous” as the investor will have no stake in the company before conversion.
- Dependency on lender's will for conversion, leading to unpredictability and risk of lender demanding repayment, potentially impacting company's viability.
- Risk of lender preferring creditor status over equity owner in case of financial distress in the company (unless the lender has previously agreed to postpone his claim, according to art. 725b al. 4 CO).
For the Investor
Advantages:
- Potential for early entry into promising ventures, through participation to a potential increase in the value of the company.
- Alignment of investor interests with start-up success.
- Mitigation of risk through option for debt repayment (plus interest).
Disadvantages:
- Lack of social or property rights for investors until conversion is carried out.
[1] Maestretti Massimiliano/FerroLorenza, Il finaziamento convertibile, in NF 7/2021, p. 400
[2] DuPasquier Ulysse, Le financement d’une jeune société,Helbing Lichtenhahn (2019), p. 442.
[3] Inaccordance with the general articles on offset, art. 120 ff of the Swiss Codeof Obligations (“CO”; SR 220).
[4] DuPasquier, p. 443.
[5] Ibid.
[6] Art.634a para. 3 CO stipulates that the articles of association must specify theamount of the contribution to be offset, the name of the shareholder, and theshares to which he or she is entitled.
[7] Maestretti/Ferro, p. 401 ; art. 312 CO.
[8]Shareholder’s loan agreement should comply with market conditions (arm’s lengthprinciple), for an in-depth analysis see Houdrouge Tarek/Ah ChoonJean-Jaques/Maraia Jean-Frédéric, Liberté et limites en matière de créancesd’actionnaires, in Notalex 1/2017.
[9] See inparticulars, dispositions of the Federal Financial Service Act (SR 950.1),Federal Bank Act (SR 952.0) and its ordinances.
[10] DuPasquier, p. 450.
[11] DuPasquier, p. 451.
[12] DuPasquier, p. 450.
[13] Maestretti/Ferro, p. 403.
[14] DuPasquier, p. 452.
[15] For adetailed analysis, see DuPasquier,p. 445-446.
Florencia Lorca Weyer
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