Convertible debt: 5 key questions for private companies and investors

We have seen a number of private companies issuing and investing in convertible debt in recent months. In this blog we explore the trend by looking at 5 key questions for private unlisted companies and investors in them to consider.

1. What is a convertible debt instrument? 

Typically, it is a loan, bond or loan note which gives the lender/holder the right to convert its right to receive repayment of the instrument into newly-issued shares in the borrower/issuer.

2. Who issues convertible debt?

Convertible debt instruments are a flexible way for new companies to raise the funds they need to develop their business. Start-ups with a short track record and limited capital can use convertible debt instruments to bridge to an equity funding round, for example. 

Equally, more established smaller companies which are embarking on a period of growth or a new venture, might use convertible debt instruments as a way to tap new funding sources where there is insufficient appetite to issue shares.

3. How do they work?

The convertible debt instrument will have many of the hallmarks of a typical loan or bond, for example:

• specified procedures for drawdown of the loan/issuance of the bond.
• interest accrues and is payable on certain dates.
• a final repayment date for full repayment of the instrument at maturity.
• representations, covenants, and undertakings.

In addition, it will have some other features specific to a convertible instrument, such as:

• a right which can be exercised by the lender/holder in certain circumstances or in a specified period, to convert the instrument into shares (at a specified price or into a specified percentage of the equity outstanding at that time), or an obligation (rather than a right) for the lender/holder to convert the instrument into shares in certain events or after a certain time.
• some specified events which trigger repayment rather than conversion – such as insolvency events, change of control, or disposal of materially all assets of the issuing/borrowing entity.

4. What’s in it for the borrower/issuer?

Putting a convertible instrument in place can, depending on the applicable corporate law of its place of incorporation, be quicker than issuing new shares, which may have a process associated with it set out in the company’s articles of association (although in many jurisdictions such as the UK the extension of an option to acquire shares in the future would require approvals to be in place on the issuance of the instrument). 

Deal participants should also consider pre-emption rights in the applicable corporate law and in any shareholders agreement. 

Issuing new shares may also involve substantial documentation or may require consent from other investors (although sometimes a convertible instrument will also require consent from external lenders and will often also require consent in some form from the existing shareholder base). 

A convertible instrument is a bilateral agreement between borrower/issuer and lender/holder which can usually be agreed more quickly, therefore it can be a swift and efficient way to raise funds. 

Generally, convertible debt will be cheaper than conventional debt because of the conversion rights attached to it.  

Finally, as the lender/holder will not have voting rights until conversion (although many instruments do offer them some form of minority protections and often attempt to treat them as deferred or contingent shareholders prior to conversion), this reduces its influence over the borrower/issuer.

5. What’s in it for the investor? 

Before conversion, the lender/holder has the advantages of a debt investment, such as:

• a claim on a convertible debt instrument is a debt and so will rank higher than equity on an insolvency of the borrower/issuer.
• the lender/holder might have the right to require repayment of the instrument in cash in certain circumstances (which will be negotiated) which an equity investor would not have.
• as an early investor in the borrower/issuer, the lender’s/holder’s conversion right is likely to be at discounted price (as compared to the public convertible markets where conversion would always be at a premium to current market value).

Following conversion, the lender/holder has the advantages of equity, for example:

• the right to vote in shareholders’ meetings.
• the right to receive dividends.
• benefiting from any increase in the share price over time.

For these reasons, sometimes a convertible instrument is an appropriate way to invest in a company or for a company to raise funds. If you are considering a convertible instrument, or if you have any questions about the points covered in this blog, please contact any of the authors. 

Our Transactions page includes additional blog posts and information on transactions you might be considering.

This material is for general information only and is not intended to provide legal advice.

This blog is up to date as of 30 May 2022.