From loan to equity: understanding convertible loan conversion

You have clearly identified that a convertible loan is the instrument of choice for an investment, but you are wondering how and when the debt stemming from the loan will actually be converted into shares? Find the answers to these questions here.

How is a loan actually converted into shares?

The conversion of loan constitutes its transformation into equity. This involves the company issuing new shares to the creditor in counterpart for the creditor’s contribution of the debt relating to the loan.

This contribution is generally realized at an extraordinary general meeting of the company, which decides to issue the new shares.

This has several important implications.

Securing enough shareholder votes in advance

Firstly, the convertible loan agreement must be countersigned by a sufficient number of shareholders to ensure that a sufficient majority of shareholders will vote in favour of the conversion. It may be very useful for the company’s shareholders to authorise the company to enter into additional convertible loans on terms set out in a template agreement, the terms of which they approve in advance (in order to avoid having to sign the various convertible loans that will be entered into with investors).

The formalities conversion brings back

The conversion itself requires the involvement of a notary and a special report from the company’s management body, as well as a report from an auditor or the statutory auditor. It also requires the lenders to adhere to the company’s shareholders’ agreement. These are the same formalities and costs that the company avoided when it took out the convertible loan, but often in the context of a larger equity investment, which in any case requires notarisation and puts the costs involved into perspective.

When can the convertible loan be converted into shares?

The conversion of debt into shares in the company is generally linked to the occurrence of one of the following triggering events:

• equity financing (venture capital) of a significant amount (thus excluding convertible debt instruments or other mezzanine financing or the implementation of employee profit-sharing schemes),
• an exit of the company, which generally means a change of control of the company, an IPO or the sale of all or substantially all of the company’s assets (it is important to align this definition with the one used in the shareholders’ agreement, if applicable), or
• reaching the maturity date of the convertible loan.

How many shares will investors receive when they convert their convertible loan?

The number of shares the investor will receive on conversion depends on the retained price per share, which depends on the valuation of the company at the time of conversion.

The price per share for conversion will be the one used at the time of the triggering event that enabled the conversion, i.e. the price per share in the case of an equity investment (venture capital) or the price per share in the case of an exit, or the value set on the basis of a formula or by an independent expert in the event of the loan reaching maturity.

Most of the time, a discount and a maximum valuation (cap) will be applied to this reference value.

Because these mechanisms interact, the final number of shares issued on conversion is not always intuitive. To make this easier to understand, you can use our convertible loan simulator, which allows you to test different assumptions (valuation, discount, cap) and see how many shares investors would receive in each scenario.

Who can decide to convert the loan?

The question remains, however, who can decide on conversion if a triggering event occurs. Contractual freedom prevails and three options are possible:

• the lender decides (in the case of several lenders, either individually or collectively on the basis of the majority of lenders and/or the amount lent),
• the company decides (with substantial compensation for non-conversion, often equivalent to the value of the discount that would have applied to the refused conversion), or
• conversion is automatic on the occurrence of the triggering event.

In our experience, the lender will require the option to convert or not.

Finally, don’t forget that if the convertible loan is not converted, it will have to be repaid.

FAQ

How is a convertible loan actually converted into shares?

Conversion is the transformation of the loan into equity. The company issues new shares to the creditor in return for the contribution in kind of the receivables arising from the loan. This is implemented through an extraordinary general meeting of the company, which resolves to issue the new shares.

What events trigger the conversion of a convertible loan?

Three triggering events are generally used: an equity financing round of at least a certain amount, an exit (change of control, IPO, the sale of all or substantially all of the company’s assets, etc.) and the loan reaching its maturity date. Where a shareholders’ agreement exists, the definition of an exit should be aligned with the one it uses.

Who decides whether a convertible loan is converted?

This depends on the terms of the agreement. Three main approaches are possible: (i) the lender decides, (ii) the company decides (with substantial compensation for non-conversion, often equivalent to the value of the discount) or (iii) conversion is automatic once the triggering event occurs.

In Beyond’s experience, lenders will generally require the option to decide whether or not to convert.

Why must a convertible loan agreement be countersigned by a sufficient number of shareholders?

Because conversion requires the approval by an extraordinary general meeting. A sufficient majority of shareholders must therefore support the conversion when the time comes.

To simplify future financings, the shareholders can also authorise the company in advance to enter into additional convertible loans on the basis of a template agreement whose terms they have already approved. This avoids having to obtain their signatures for each new convertible loan.

What formalities and costs does converting a convertible loan involve?

Conversion requires the involvement of a notary, a special report from the company’s management body and a report from an auditor. The lenders generally also need to adhere to the company’s shareholders’ agreement.

These are essentially the formalities and costs that the company avoided when it took out the loan. In practice, however, conversion often takes place as part of a larger equity financing that already requires (some of) these formalities and costs, which diminishes their impact.