William Robins explains how investors and companies seeking investment can benefit from using convertible debt, a common investment structure in the US.

Convertible debt is a common investment structure in the United States which is now gaining traction in England and Wales. William Robins explains how investors and companies seeking investment can benefit from using convertible debt.

What is convertible debt?

Convertible debt is also known as a ‘convertible loan note' or just a ‘loan note'. It refers to any type of investment made initially by loan that can or must later convert, in whole or in part, to an equity investment.  It is an extremely flexible investment vehicle and it can be used in many ways.

How is convertible debt different?

There are significant differences between an equity investment and an investment by way of convertible debt.  The most important difference, however, lies in the way that the shares being bought are valued. 

In a traditional equity investment the investor would value the business before investing and compute an agreed price per share.  Convertible debt works totally differently.  The investment is made initially by way of a loan.  The loan will yield a commercial rate of interest and may even be secured.  Upon a trigger event the loan may, or perhaps must, be converted into equity.  There are myriad different conversion mechanics, but the one most often employed involves valuing the company at the time of conversion, applying a pre agreed discount factor in lieu of capital growth from the time of investment until the time of conversion and then exchanging the debt for equity at that discounted price.

In almost all cases the trigger event is the next round of investment, by which time the company has grown and become much easier to value.  Moreover, it is now worth a sufficient amount that a second round investor, generally a professional investor, will allocate the time and resources required to value the company as accurately as possible.

The effect therefore is that the first round investor can rely on the second round investor to incur the significant costs of reaching a definitive valuation and simultaneously avoid the risk of having paid too much.  From the company's point of view it can make the first round easier and quicker to close.

The advantages of investing through convertible debt

Unquestionably the greatest advantage of investing via a convertible debt is the fact that it can circumvent lengthy and potentially harmful negotiations about valuation of the business.  This is especially compelling where the investor is a family member or an inexperienced investor.  Such an investor would have little interest in a costly and lengthy valuation of the company.

Loan investments also have a slightly reduced credit risk.  Convertible loan monies are repayable before any equity holder receives any payment on insolvency and the investor has, subject to the terms of the document, the freedom to call the convertible loan at any time in order to mitigate any loss of the invested principal.  In addition to this, the convertible loan investors can take security for their investment in any applicable form, including a charge over:

• a patent
• the intellectual property
• a personal guarantee
• book debts; or
• a general floating charge over the company.

Given the lower credit risk and the fact that the valuation is effectively postponed, it is possible for the investment to proceed more cheaply, quickly and with significantly less due diligence required.

A convertible loan is also very flexible.  It can take the form of a short form document or it can be drafted to the same level of sophistication as a shareholders agreement, with the convertible loan investment being treated as a separate class and enjoying almost the same minority protections (and even anti-dilution provisions if required) that minority equity shareholders have.

The disadvantages of investing through convertible debt

Using convertible debt does have its limitations.   Unless drafted properly it can prove less profitable for the investor.  Further, proper drafting can be tricky and time consuming.  For those investors who are UK tax paying individuals, it is of note that convertible debt investment would not qualify for Enterprise Investment Scheme relief.  Finally, it has been argued by seasoned investors in the past that circumventing a discussion on valuation is  unwise.

Conclusion

Despite its shortcomings, in the right situation convertible debt can prove extremely useful for investors and companies seeking investment. 

There are two situations in particular where convertible debt is particularly apt.  The first is, as already mentioned, during a friends and family round.  At such times the friend or family member has no ability or inclination to value the business.   Given it is so hard to value a business at that time, using convertible debt can save a falling out if the ultimate value proves less that the founder first thought. 

The second situation is where there is a significant event on the horizon that will change the valuation, but money is still required in the short term.  This might be a further round of funding, a big order, and the grant of a patent or a key licence.  Providing it is not too far in the future, the parties often agree to postpone valuing the business until after such an event.

This article is written by William Robins, a solicitor in Keystone's Corporate Finance Team. To find out more, refer to www.keystonelaw.co.uk, call 020 7152 6550 or email enquiries@keystonelaw.co.uk  Please note this article is for general information purposes only and does not constitute legal or professional advice. It should not be used as a substitute for legal advice relating to your particular circumstances. Please note that the law may have changed since the date of this article (March 2011)