Convertible loans: A practical look | In Principle

Convertible loans are still a relatively rare debt financing instrument in Polish practice, but have recently gained popularity among startups and in venture capital. In essence, a convertible loan involves granting a loan that may be repaid by converting the debt into equity in the borrower. But depending on the expectations, circumstances and identified risks, the loan provisions can differ widely, with flexibility to modify the positions of the parties. This means it is worth paying attention to a number of financial and legal parameters, including obvious ones that can affect the feasibility of the undertaking.

Genesis and application

Convertible loans appeared on the Polish market as a response to the need to adapt the American solution of the convertible note to suit the local legal framework. The essence of a convertible note is granting debt financing based on the classic interest and maturity mechanism, which can be repaid at a later date by way of conversion into preferred shares of the borrower. Usually conversion takes place during a qualified investment round or when other specified events occur. This mechanism has been in place in the US since the 19^th century, and due to its simplicity it was adopted by private investors and investment funds to finance early-stage ventures with high investment risk.

A distinction should be made between a convertible note and another popular mechanism, the simple agreement for future equity or SAFE, which is mainly distinguished from a convertible note in that it does not involve debt financing in the classic sense (and thus lacks a financial debt, interest or maturity), but only giving the investor the right to subscribe for the issuer’s shares in the future. The SAFE mechanism offers even greater simplicity and speed than the convertible note, helped by the standardisation of this form of agreement by Y Combinator in 2013.

On the Polish market, not unlike in the US, convertible loans have found widespread application primarily in the environment of startups and the venture capital (VC) or corporate venture capital (CVC) funds providing them financing, especially during a pre-seed round. Undoubtedly, this is because the convertible loan mechanism addresses several challenges typically faced by parties to transactions involving such companies. But it does have some drawbacks.

Advantages and disadvantages of a convertible loan

Lack of company valuation

First of all, a convertible loan allows the parties to avoid a conversation about the company’s current valuation, which usually takes place at the beginning of a classic investment process and often generates tensions. On one side there are usually the founders, with a team of at most a few people, and a product still at an early stage of development and untested in the wider market, who place great faith and optimism in further development of the product. On the other side is an investor with a lot of previous investment experience, taking a prudent view of the borrower’s financial model, business fundamentals, and current state of product development.

The clash of these two radically different perspectives causes difficulties in determining exactly how much the financing by the investor will be reflected in the company’s share capital. A convertible loan offers a solution to this problem, as the conversion, where the investor “joins” the company, is postponed (usually for the next two to three years) until the company’s business model begins (or at least should begin) to be reflected in the market realities, and a new investor appears, with the prospect of a larger round of financing. In such circumstances, the valuation is more solidly grounded in the realities of the business.

Speed in providing financing

Another key advantage of a convertible loan over the classic investment process is the reduction in the amount of documentation required to close the loan, and thus the time spent by the parties and their advisors on negotiations. Under the most common variant we observe on the market, the investor refrains from conducting extensive due diligence, submitting comprehensive representations and warranties as to the current state of the company, as well as negotiating provisions on the founders’ liability or the corporate governance principles applicable in the company. Thus the path from taking a business decision to provide financing, to the actual transfer of money to the company’s account, is significantly shortened.

Lack of supervision

In the classic investment process, investors expect the company to establish complex corporate governance rules binding on the company and the founders, including placement of investor representatives on the company’s supervisory board, or less frequently on the management board. As indicated above, in the process of raising funds under convertible loans, in principle the parties do not negotiate covenants of this kind, postponing this discussion until later finalisation of a full investment round.

Rollover of funding

The flexibility of the convertible loan mechanism should also allow the founders to raise successive tranches of convertible loans over an extended period, without the need to close the entire process with one group of investors in one step. This freedom for the founders to take on debt even ad hoc stands in contrast to the classic investment process, which assumes that a group of investors will be focused in a single process, requiring the time of at least several professional firms for simultaneous negotiations, which requires a significant allocation of time and resources. For these reasons, a convertible loan can be seen as a form of bridge financing functioning well between larger investment rounds.

Maturity

A convertible loan is an instrument carrying some risks as a direct result of its legal and financial nature. One obvious aspect is the need to repay the debt incurred. If the expectations of conducting an investment round within a certain time frame are not met before the debt maturity date, the company will face a serious challenge of having to repay the debt or undertake difficult discussions about refinancing, but from the weaker position of a less reliable entity not paying its obligations on time.

Risk

From an investor’s perspective, this indicates the real level of risk of this instrument, materialising precisely in the situation of failure to repay the debt financing, whether as a result of failure to complete a qualified investment round (and as a result the inability to convert the debt into share capital) or lack of current cash to settle the debt. This risk is exacerbated by the uncertainty about the future fate of the company and the product it is developing in light of its brief operating history as well as the aforementioned lack of corporate control over the company itself and the founding team. Therefore, providing financing in this form often requires a high level of trust and business understanding between the parties, as well as a healthy appetite for risk on the investor’s part.

Time pressure

A distinctive feature here is the time pressure imposed on the founding team, who will have to efficiently manage the company’s financial policy, properly timing the investment round in view of the upcoming debt maturity date.

Dilution

On the other hand, if the investment round is conducted successfully and at a favourable valuation, the boundary conditions contained in the convertible loan documentation capping the company’s maximum valuation and providing a discount on the issue price set in the round (as discussed below) may apply. This will lead to greater dilution of the founders compared to conversion after a valuation directly resulting from an investment round.

While at first glance this may seem beneficial to the investor providing debt financing (a larger stake in a better valued company), excessive dilution of the founders’ stake may reduce their motivation to further commit to the project and make it harder to conduct further investment rounds, which will inherently lead to even greater dilution of the founders and possibly a proportional decrease in engagement. However, it can be rightly argued that this is a premium for the proportionally larger risk of the lender providing such financing.

Distinguishing elements of a convertible loan

The Polish Civil Code does not directly regulate convertible loans as such. From a legal perspective, a convertible loan agreement will need to contain the essential terms for a loan agreement under Civil Code Art. 720 §1. On one hand, the lender (investor) undertakes to transfer to the borrower (company) a certain amount of money, while the borrower (company) undertakes to return the same amount of money to the lender (investor), plus, in principle, a contractually specified amount of interest. But a convertible loan agreement has at least several elements differing from a classic loan agreement under Art. 720 §1, in particular:

• Inclusion of a mechanism for converting the debt into share capital in the borrower
• Rules for repayment of the debt by conversion or in cash
• Financial indicators reflecting the investor’s risk premium for providing debt financing.

Conversion mechanism

The first of these elements, and the key, is introduction of an additional form of loan repayment by way of conversion into the borrower’s share capital. From an economic perspective, this means that the debt arising from the loan is settled by issuance of shares to the lender. Within the limits of freedom of contract under Civil Code Art. 353¹, the parties may flexibly regulate the terms of repayment of the loan in this regard. In particular, they may choose a conversion mechanism that they consider more appropriate for themselves, which may be dictated for example by tax considerations.

From a legal perspective, conversion of a loan into capital always involves the issuance of new shares to the lender i.e. the investor. The number of shares issued, their par value and the issue price should result from the financial parameters set by the parties in the convertible loan agreement and from the investment round (if has been conducted). The issue price for shares issued to the lender may be equal to the issue price for shares issued to investors participating in the investment round, or most often reduced accordingly (as discussed below). But depending of the parties’ choice, the newly issued shares may be covered by either an in-kind contribution or a cash contribution.

Making an in-kind contribution consists in the lender transferring to the company the claim under the convertible loan agreement for repayment of the loan plus interest. As a result, the company’s claim for payment of the issue price will be satisfied upon execution of the relevant in-kind contribution agreement, and the claim for repayment of the loan principal and interest under the convertible loan agreement will be extinguished because the company will become both the creditor and the debtor under the same claim.

In the case of a limited-liability company, Polish law does not provide a detailed mechanism for verifying the value of in-kind contributions (here, a claim) to cover new shares, only requiring the management board to declare when registering the share capital increase that the consideration for the shares has been fully paid. But in the case of a joint-stock company, such a mechanism is provided for in the form of an obligation to prepare a report on valuation of the in-kind contribution under Art. 311 §1 of the Commercial Companies Code, to be audited under Art. 312¹ §1 (or the audit may be waived in certain cases indicated there). This is to ensure true coverage of the value of the newly issued shares. Consequently, the conversion mechanism for a joint-stock company will require additional corporate actions.

Alternatively, the parties may decide to cover the newly issued shares by a cash contribution, requiring the investor to cover the newly issued shares in cash in an amount equal to the company’s existing debt under the convertible loan agreement. Since, in this configuration, the investor (lender) will be a creditor of the company for repayment of the debt, while at the same time the company will be a creditor of the investor for the cash contribution in the same amount, the parties can make a contractual setoff of both claims (avoiding in this case the statutory limitations under Civil Code Art. 498–508 of the Civil Code), or the company can make a statutory setoff under the rules in Art. 498–508, as a result of which both claims will be extinguished.

For clarity, we should mention that under Art. 14 §4 of the Commercial Companies Code, a shareholder is prohibited from setting off claims it has against the company, against the company’s claim for the shareholder to pay the amount due for the shares. However, this does not exclude the possibility of conducting a contractual set-off, or indeed, as indicated in the legal literature, a unilateral statutory setoff by the company.

In the case of a non-public joint-stock company, the use of this cash increase and setoff mechanism allows the parties to work around the provisions indicated above on verification of the value of in-kind contributions, sometimes referred to as making a “latent in-kind contribution.” In the view of lawmakers and the Polish Financial Supervision Authority, this exposes investors to the risk of incomplete coverage of the share capital. But it is clear in the legal literature that there is no legal basis for classifying such a legal construction as an in-kind contribution.

This issue was directly addressed by the legislature in the case of listed companies in 2019, by adding the new Art. 6a to the Public Offerings Act of 29 July 2005. This provision is analogous to the current Art. 311–312¹ of the Commercial Companies Code, i.e. an obligation by the management board to prepare a report when there is an intention to make a setoff, which report must be audited for accuracy and reliability. The lack of such a rule for non-public joint-stock companies can be explained by the statistically lesser fragmentation of shareholding in closely held companies, compared to public companies, and also the smaller scope for impacts if the risks identified by lawmakers and regulators materialise.

From an economic perspective, both a cash contribution and an in-kind contribution have the same result, i.e. settlement of claims and liabilities under the convertible loan agreement on one hand, and a new issue of shares on the other.

Debt repayment rules

The parties can also decide whether repayment of the loan via the conversion mechanism is mandatory (most often when certain conditions are met) or the investor can elect how it will be repaid. Such provisions may prove crucial from the perspective of the company incurring the debt, since the fundamental intention in taking out a convertible loan is to allow it to be repaid by conversion rather than in cash, which could disrupt the company’s financial policy. Again, within the limits of freedom of contract, the parties have a great deal of latitude in how they address this issue. Some of the variants include:

• Allowing repayment both in cash and by conversion to share capital, where:
  • The form of repayment may be left to the free choice of one of the parties, regardless of whether certain conditions are fulfilled
  • Conversion may be mandatory if certain conditions are met, and if these conditions are not met by the agreed maturity date, repayment may have to be made in cash, or the form of repayment may be left to the free choice of one of the parties to the agreement—the most commonly observed model in practice
• Allowing repayment only by conversion to capital, which would make this legal construction more similar to the SAFE mechanism.

As a model, a condition triggering the possibility (or obligation) to convert debt to capital is completion of a qualified investment round, i.e. a share capital increase meeting certain financial parameters, for example as to the number of new investors taking equity in the company and most importantly as to the issue price covered by such investors. This is because the issue price implies a valuation of the company during the investment process, and thus verification by the market, a step that was postponed when the convertible loan was taken out.

It should be noted that the need to establish the company’s valuation meeting the parameters of a qualified investment round reopens the problem that the convertible loan was supposed to solve, namely the lack of a need to establish the company’s valuation at an early stage of development. But setting a valuation floor, rather than indicating a specific valuation, should be much simpler for the parties.

In such a situation, most often the lender joins the investment round so that new shares are issued to investors participating in the investment round and are also issued to the lender to carry out the debt-to-equity conversion in a single share capital increase. It would also be possible to carry out a separate share capital increase aimed directly at the lender, after completing the share capital increase as part of a qualified investment round.

The parties do not have to link conversion exclusively to a qualified investment round. Among other things, the conversion can instead be triggered by other events such as:

• Conducting any financing round (i.e. any share capital increase), but this is not frequently observed in practice, if only because it could risk significant dilution of the founders’ stake with a low-valued investment round, which could be unfavourable to both parties (as discussed above)
• Passage of a certain amount of time, regardless of whether an investment round has been conducted—but this would open up negotiations about the company’s valuation on that date, which parties to financing through a convertible loan may wish to avoid
• Occurrence of some other condition, regardless of the occurrence of any investment round—most often a specific event of default under the documentation, ceasing to service the existing debt, or an organised sale of the company.

Financial parameters—discount and cap

Given the investment risk inherent in financing through a convertible loan, it is standard practice to introduce mechanisms in the transaction documentation to reflect the premium to the investor for assuming this risk. These mechanisms will result in a corresponding reduction of the issue price for shares issued to the lender under the conversion, below the issue price for shares issued to investors participating in the investment round.

The first of these mechanisms provides for a direct discount to the lender against the issue price at which shares are taken up by investors in an investment round. The discount would be a percentage value lowering the issue price for shares taken up by the lender participating in an investment round, below what other pari passu investors would have to pay.

The second mechanism introduces a cap on the valuation of the company established in an investment round. As a result, if the investment round sets a valuation of the company exceeding the cap, the valuation at this upper limit would be adopted for conversion purposes. The effect of this operation will be the same as in the case of a discount, as the issue price of shares for the lender would be lower than the issue price for investors involved in the investment round.

These mechanisms are obviously beneficial to the lender, rather than the company, as they allow the lender to achieve a higher equity stake in the company than if the conversion were done under the same terms (at the same issue price) that apply to the investors involved in the investment round.

The most commonly observed model in practice is to choose one of these two mechanisms, but there is nothing preventing them from being applied together—although this would in a sense compensate the lender doubly and thus be difficult for the company to accept. Since the cap mechanism opens up a discussion of the valuation of the company (as would the possibility of conversion when no qualified investment round has occurred by a certain date), the discount mechanism may be simpler for the parties to apply.

Additional legal elements to consider

In addition to the legal elements characteristic for a convertible loan indicated above, depending on business needs and expectations, the parties may consider expanding the transaction documentation to include additional regulations. Since in its essence a convertible loan contains elements of both debt financing and equity financing, the transaction documentation can be supplemented by legal constructions specific to those two processes.

Financing tranching (milestones)

First of all, the debt financing provided under a convertible loan may not be disbursed at once, but may be paid out in tranches over time. Tranching can be structured so that disbursements are conditioned on fulfilment of certain conditions or passage of a certain amount of time.

This makes sense from the lender’s perspective, as further engagement of resources can be conditioned on the company achieving certain business objectives, often referred to as milestones. In that case, it should be ensured that the conditions are formulated in an objectively verifiable manner, reducing any discretion in assessing their fulfilment and thus the risk of litigation between the parties.

Security

Granting of debt financing has traditionally been linked to establishment of a catalogue of security interests for repayment of the financing, in the form of personal or material collateral. But given the nature of a convertible loan, it can be problematic to determine the appropriate collateral (if any).

This may happen because often companies interested in obtaining a convertible loan are at a very early stage of business development and do not have any tangible or intangible assets that could provide substantial security for the lender’s claims. And the borrower will rarely be part of a larger capital group that could provide support in this regard (if they were, the financing would come from the group first, not from an external investor). For these reasons, in practice convertible loans are often unsecured.

Often, the only substantial collateral could be a personal guarantee provided by the founders, or a pledge of their personal assets. For obvious reasons, such an expectation may be difficult for the founders to accept. An intermediate solution could be for the founders to pledge their shares in the company itself as collateral (if the investor sees any value in such collateral).

Corporate governance

As indicated, the model transaction documentation for a convertible loan does not include any extensive corporate governance provisions applicable to the company during the period of financing. But depending on the expectations of the parties, such provisions may be introduced.

The scope of these provisions can vary widely, largely corresponding to the provisions typically found in a shareholders’ agreement. The investor’s main aim is to ensure that the company operates within its budget and according to a business plan, and does not take certain actions without the investor’s approval. The investor may also insist on an undertaking to keep the investor informed of the company’s situation going forward.

Corporate governance provisions should be examined in detail for compliance with legal regulations, particularly to manage the risk of “gun jumping.”

An extensive set of rules in this regard somewhat contradicts the concept of a convertible loan, which should allow the transaction documentation to be ironed out quickly and provide founders with the freedom to continue pursuing their business. And such provisions would have to be revised anyway in the course of finalising an investment round, as the investors participating in the round will typically expect to establish comprehensive new corporate governance rules to protect their investment.

Representations and warranties

The classic investment process involves meticulous due diligence review of the target, and drafting of an extensive set of representations and warranties by the seller, reflecting the risks identified in the due diligence. Because this process requires considerable time and resources, it can be problematic in the process of obtaining a convertible loan.

Nonetheless, the investor may have a reasonable expectation of conducting at least limited due diligence of the company, such as a technical examination of the product being developed by the company and submission by the company and the founders of a limited set of representations and warranties regarding the company itself. But opening such discussions will inevitably also make it necessary to agree on the rules for liability in the event of breach of the representations and warranties, which may prolong the negotiations.

The parties to a convertible loan agreement

In addition to the investor acting as the lender, and the company acting as the borrower, the parties to a convertible loan can be expanded for various purposes.

For example, the founders may be added as parties to the loan agreement for the purpose of:

• Holding them to the commitment to carry out the conversion under the agreed terms and conditions
• Establishing corporate governance rules applicable to the company during the financing period
• Providing security for repayment of the loan.

Conclusion

A convertible loan is a flexible debt financing instrument increasingly used on the Polish market, following the example of American practice. It is to be expected that with the growth of the startup market and VC/CVC funds, it will become a permanent part of the local financing structure. It allows funds to be raised from investors relatively quickly, without complex, prolonged transaction processes, while appropriately rewarding investors with a premium for the risk they assume.

Under Polish law, a convertible loan carries over the well-established regulations governing loans, with the necessary addition of rules for carrying out a debt-to-equity conversion or repayment of the loan.

Depending on the parties’ expectations, the transaction documentation may be further expanded to include institutions familiar from the traditional equity investment process (such as establishing corporate governance rules or introducing an extensive set of representations and warranties) or the debt financing process (tranching of loan disbursements or establishing a set of security interests). But in each case, the parties must weigh and balance their interests and objectives.

Adam Pawlisz, adwokat, Dominik Kaszuba, M&A and Corporate practice, Wardyński & Partners