Control Without Equity: Key Terms in Convertible Loans

When investors invest through a convertible loan, they often seek to secure advantages similar to those they would obtain by directly acquiring shares in the company. As a founder, it is crucial to understand which clauses can be negotiated and how far to give in without compromising the flexibility of the convertible loan. This article sheds light on the main demands made by investors and how to meet them without diluting your control prematurely.

Why a lender is in a weaker position than a shareholder

In the case of a convertible loan, investors will generally find themselves in a less favourable position than if they had invested in shares.

On the one hand, in the event of the company’s success, and subject to the important proviso of the possible moderating effects of the discount and the maximum valuation (cap), investors are likely to see the dilutive effect of their conversion reduced compared with an investment in the company that they would have made immediately in shares.

On the other hand, if the investor had invested in shares, he would have received shareholder rights by law and also under a shareholders’ agreement that he would certainly have taken the trouble to negotiate. As such, the investor would have been able to influence the company’s governance, the mechanisms governing share transfers, the exit strategy and impose constraints on the founders (non-compete and non-solicitation, temporary standstill on transferring shares and good/bad leaver clauses).

Why investors ask for special rights in the loan agreement

Some professional investors, particularly investment funds, will try to obtain special rights under the convertible loan agreement in order to temper the loss of rights they would have had if they had invested in shares. Historical shareholders may also take the initiative of offering these rights in order to reassure prospective investors who are reluctant to invest via a convertible loan.

Information and control rights/governance

Prior to conversion, the lender is considered to be a mere creditor, which means that in principle it has no say in how the company operates and no role in its governance. This is fundamentally different from shareholders, who have various rights under the companies and associations Code, the company’s bylaws and the shareholders’ agreement. As a result, the convertible loan agreement usually includes certain clauses giving them a right to information and a right of audit, and in some cases even a veto right over certain important decisions (which, if not agreed, would result in the conversion of the loan or its immediate repayment). Some investors also ask to have an observer seat on the board of directors.

Active role of founders/keeping the founders in the company’s shareholding structure

Maintaining the activity of founders is a conditio sine qua non for investment in startups and scaleups. In the case of equity investments, this condition is sanctioned in shareholders’ agreements by good/bad leaver clauses authorising shareholders, or even the company itself, to buy back the founders’ shares. To ensure that this condition is respected when investing in a convertible loan, the investor may require that the inactivity (inexcusable or unapproved, obviously) of one or more founders, without a satisfactory replacement within a certain period, constitutes grounds for immediate repayment of the convertible loan. The same sanction may apply in the event a founder sells all or part of his shares in the company within a certain period of time from the date on which the loan was taken out.

Non-compete and non-solicitation

As emphasised earlier, the exit of a founder, either as a member of the staff or as a shareholder in the company, is non-negotiable for investors. Consequently, such an exit, which would be accompanied by a move to competitor, is a totally unbearable situation for any investor (as for any other stakeholder, for that matter…). Such a situation should also give rise to immediate repayment and/or a penalty payable directly by the founders to the investor. We obviously recommend limiting the sanction to the founder’s penalty, otherwise the company (and indirectly the historical shareholders) will be subject to a double penalty: the departure of a founder and the early repayment of the loan.

Future shareholders‘ agreement

More generally, when the loan is converted, the lender must adhere to the company’s shareholders’ agreement. If this agreement needs to be amended at that time, the lender should therefore ensure that the convertible loan agreement already contains the provisions of the agreement that it wishes to see implemented or amended.

FAQ

Why does a lender under a convertible loan have fewer rights than a shareholder?

Before conversion, the lender is a mere creditor rather than a shareholder and therefore in principle, has no role in the company’s governance or decision-making. A shareholder, by contrast, benefits from rights under the Belgian companies and associations Code, the company’s articles of association and, where applicable, the shareholders’ agreement. Some professional investors, particularly investment funds, therefore seek to obtain specific contractual rights under the convertible loan agreement to compensate for the rights they would otherwise have had as shareholders.

What information and control rights can an investor negotiate in a convertible loan?

A convertible loan agreement usually provides an investor with information and audit rights. In some cases, the investor may also negotiate a veto right over certain important decisions, with a breach potentially triggering conversion of the loan or its immediate repayment. Some investors also request an observer seat on the board of directors.

What happens if a founder stops being active in the company?

An investor may require that the unapproved or unjustified inactivity of one or more founders, without a satisfactory replacement within a certain period, triggers the immediate repayment of the convertible loan. A similar consequence may apply if a founder transfers all or part of their shares within a certain period after the loan is granted. For equity investments, similar concerns are generally addressed through good/bad leaver provisions and restrictions on share transfers in the shareholders’ agreement.

Can a non-compete clause be included in a convertible loan agreement?

Yes. A founder leaving and joining a competitor generally triggers immediate repayment of the loan and/or a penalty payable directly by that founder to the investor. Beyond recommends limiting the sanction to a penalty payable by the founder rather than also requiring early repayment of the loan. Otherwise the company (and indirectly the other shareholders) suffers a double penalty, loss of a founder and early repayment of the loan.

Does the lender have to adhere to the shareholders’ agreement when a convertible loan is converted?

Yes, adherence to the shareholders’ agreement should take place at conversion. If the investor expects that agreement to be amended upon conversion, it should therefore ensure that the convertible loan agreement already identifies the provisions it wants to see introduced or modified.