The time has come to convert some company debt into equity – make sure you are prepared!

Background

There are two main ways for a company to raise investment – primarily this will be achieved through repayable loans or subscribing for equity (shares in the business). However, there is also a third option, whereby existing debt (loans) are converted into equity rather than being repaid in cash to a lender. This can help clear debts to improve a company’s balance sheet, while retaining cash in the business – which can be vitally important during the pre-revenue stage. The flip side is that the lender becomes a shareholder and therefore takes a proportion of ownership in the business, further diluting the founders and existing shareholders/investors. Converting debt into equity requires specific legal documentation and consideration around the commercial terms, therefore it is important for a company to be well prepared in sufficient time before the conversion takes place.

Conversion Terms

Whether a debt is convertible into equity is normally pre-agreed at the time of entering into the loan. In such instances, the loan instrument (loan agreement or loan note instrument) is deliberately drafted to include set conversion terms. If the loan instrument was previously drafted without conversion terms, the parties can still agree to formally amend the document to include such.

The key commercial terms contained in a convertible loan instrument are:

• Conversion Event – It is likely that a conversion shall be triggered by an exit event or future fundraise (over a specific materiality threshold) by the company. However, the documentation can also provide that a lender may positively elect to convert at any point during the term (or at the maturity) of the loan or even that no conversion takes place without such an election. In many cases a company will want the debt to automatically convert at the next funding round.

• Share Class – It is common for the lender to convert their debt into the most senior class of shares available in the company at such point. If the conversion event in question is an equity fundraise (which involves a senior class of preference shares over and above the ordinary share class), the lender will usually convert into that same preference class as the new investors are subscribing for.

• Price – The loan instrument could provide for a set conversion price per share. However, it is more likely that it will be linked to the company’s fluctuating market value (mirroring the price per share being paid at an exit event or fundraise). As an incentive for providing the funds at an earlier stage, the documentation may also specify that the lender can convert at a discount to the company’s market value. In some cases it can be important to include a floor price so that a future ‘down-round’ fundraise does not over-dilute the existing shareholders.

Therefore, it is crucial to review the existing legal documentation in advance of the proposed conversion event and ensure the parties are aligned in their commercial expectations.

Legal Documentation

The documentation required to give effect to converting debt into equity will depend on the context of the conversion event and the lenders involved. As a result, it is important that the parties are considering the loan conversion well in advance, to ensure the correct legal documents are prepared which are appropriate for the transaction.

Good practice would be for any shareholder or investor consents (whether required under law or pursuant to an investment/shareholders’ agreement) to be entered into at the time of the loan instrument. If that was not done – or the commercial terms have materially changed so as to require fresh consents – obtaining these will need factored into the conversion documentation, which can impact on timescales.

In addition to various ancillary documents required to issue shares (board minutes, share certificates, Companies House forms), there needs to be a legal document giving effect to the conversion. This can take the form of a short conversion notice (which may be in a prescribed form in the loan instrument itself) or be built into the principal legal documents catering for the conversion event – i.e. the investment/shareholders’ agreement or share purchase agreement.

Tax advice

Please also remember to take tax and accounting advise before entering into any convertible debt instruments. For example, EIS tax relief does not apply to these types of instrument.

Future Fund and Early Stage Growth Challenge Fund

Due to the impact of the coronavirus pandemic, many businesses received loans from the British Business Bank’s Future Fund or Scottish Enterprise’s Early Stage Growth Challenge Fund (ESGCF). Additional considerations arise when dealing with these public bodies. Please be aware that they have their own respective internal approval processes and specific methods for executing documents, therefore it is prudent to build extra time into your transaction.

The Future Fund and the ESGCF have standard-form convertible loan instruments with specific commercial terms and particular methods and processes that require to be followed. So make sure you are reviewing the loan instruments in advance and giving them sufficient warning prior to any possible conversion event. Given their public status, the Future Fund and the ESGCF will also require a company’s equity documents (investment/shareholders’ agreement and articles of association) to be updated at the point of conversion to include specific rights to help safeguard them. Please take specialist advice if this is relevant to you because this normally entails drafting and negotiation between the company lawyers and those for the Future Fund and the ESGCF.