In the world of startup financing, a convertible note is an instrument offering several advantages for a startup seeking to raise funds in Switzerland, for example from existing shareholders, business angels or other investors. Such advantages include the following:
- the process of negotiating and concluding a convertible note or a convertible loan agreement ("CLA") can be completed in a swift and straightforward manner. This characteristic proves useful if the startup is in need of additional funding to complete a project or research, the results of which are expected to gain traction towards a successful equity for cash financing round ("Financing Round");
- while a startup generally must offer to its existing shareholders the opportunity of participating in a CLA, written support of key shareholders (2/3) is sufficient and faster to obtain. Thus no formal shareholders meeting is required for this form of financing, absent any contractual agreement to the contrary, e.g., under a shareholders' agreement; and
- concluding a CLA does not (yet) affect the participations of existing shareholders. Indeed, a dilution of their shareholdings will only incur once the loan received is effectively converted into equity of the company.
This contribution focuses on one point of contention during the negotiations of a CLA: the terms of the conversion price depending on the type of event triggering the conversion of the loan into equity. The considerations below provide a suggested approach to instances of mandatory conversion (Financing Round; Liquidity Event, as defined below) and optional conversion (if the lenders elect to convert their loan at the maturity date).
I. Conversion event at the startup's next Financing Round (mandatory conversion)
Upon concluding a CLA, a prevailing scenario contemplated by the parties is to assume that the convertible loan, alone or together with other convertible loans being entered into by the startup, will provide sufficient funding for the startup to pursue its business activities until it can raise a larger amount of funds in a Financing Round. In this instance, the convertible loan provided through a CLA would then convert into shares of the class being issued in the Financing Round. To incentivize the lender for taking the risk of granting a loan to the startup at a time when the latter has not (yet) secured investment commitments for a Financing Round, the CLA usually grants the lender a discount to convert the loan at a discount off the subscription price per share payable in the Financing Round. The size of the discount is freely negotiable and depends on several factors, such as the projected timetable until the closing of the Financing Round, the term of the CLA and the potential impact of such discount in discussions with potential investors for the Financing Round. If the convertible loan bears interest, the applicable interest rate and the fact that the convertible loan amount includes or excludes such interest will also be part of the discussion. A venture loan granted in the form of a CLA to a startup can generally provide for a discount often ranging between 10-20% of the subscription price per share in the Financing Round, corresponding to a conversion price often representing between 80-90% of such subscription price per share.
Practical tip: when defining a Financing Round as a conversion trigger in a CLA, the parties are advised to set a minimum cash amount being raised in this event and to specify whether such threshold includes the convertible loan(s) being converted in the Financing Round. Such threshold offers flexibility to the startup to conduct a small "bridge" financing (equity for cash) between the conclusion of the CLA and the closing of the Financing Round. It also protects the lender from the risk of the startup triggering a conversion in a modest Financing Round with a subscription price lower than the one likely to be negotiated in a larger Financing Round.
II. Conversion event in case of a Liquidity Event (mandatory conversion)
The occurrence of a liquidity event (which is also at times referred to as a trade sale or exit) during the term of the CLA can also cause the conversion of the convertible loan into equity. While the definition of a liquidity event may depend on several factors, it generally encompasses the following scenarios (together, the "Liquidity Event"):
- the transfer of shares resulting in a change of control (i.e., the acquisition by any person, acting alone or jointly, of more than 50% of the shares or the voting rights in the startup); or
- the sale, transfer or licensing of all or substantially all the assets of the startup; or
- a merger, consolidation or similar reorganization of the startup (excluding any financing transaction) resulting in a change of control.
Unlike the Financing Round, the Liquidity Event does not entail the issuance of new shares and, accordingly, will not establish a subscription price per share. A Liquidity Event may define a purchase price per share (e.g., in the event of a share transfer or merger), which may be useful to determine the startup's valuation assuming the underlying transaction is completed at arm's length (market) conditions. The operation causing the Liquidity Event, however, may not consider any price per share (e.g., in case of a sale of all of the startup's assets). Given the variability of the scenarios forming a Liquidity Event, a certain creativity can be used to set the conversion price mechanism. An approach that is considered as being balanced is to define the conversion price based on the per share value of the startup on a fully diluted basis at the time of conversion. Such computation rests on two elements: the startup's valuation and its number of shares on a fully diluted basis.
- Startup's valuation: the startup's valuation can be undetermined or fixed within the CLA:
- undetermined valuation: considering that a convertible loan is a hybrid instrument with equity and loan components, the startup's valuation at the time of grant of the convertible loan presumably serves as a useful starting point when emphasizing its equity feature. This approach is then justified if the loan is subordinated and unsecured, and thus in essence represents risk capital. One method could be to infer the startup's valuation at the time of grant from the economic terms of a Liquidity Event completed at market conditions. The parties to the CLA can therefore refer to such future, unknown company valuation and calculate backwards the conversion price by including a discount off the per share value of the startup at the time of the Liquidity Event;
- fixed valuation: should the parties prefer agreeing on a fixed company valuation in the CLA, they can define such valuation as (i) the startup's current valuation or (ii) an agreed higher valuation based on the startup's projections during the term of the CLA. The upside of setting a fixed company valuation is that it should avoid discussions on that topic if a Liquidity Event materializes and the stakes become higher. A pre-determined company valuation works as a cap, and benefits the lender of the convertible loan in case of an early exit potentially more than the discount such lender would have been eligible to receive in the next Financing Round.
- Number of shares on a fully diluted basis: this figure generally corresponds to the sum of (i) all issued shares in the startup plus (ii) any options granted under the startup's employment incentive plan.
III. Conversion event upon reaching the CLA's maturity date (optional conversion)
If, by the maturity date, no instance of mandatory conversion (Financing Round; Liquidity Event) occurred and the parties do not extend the term of the CLA, a lender usually has the option of requesting either the reimbursement of the convertible loan (plus interest, as the case may be) or the conversion of the loan into equity. In the latter instance, the basis for determining the conversion price could be the subscription price per share applied in a previous Financing Round completed by the startup. Depending on the circumstances of the case at hand, in particular the duration of the CLA or the time lapse between the startup's most recent Financing Round and the conclusion of the CLA, the conversion price may be e.g. 10-20% higher than the subscription price per share applied in the relevant Financing Round. Through this mechanism, the parties to the CLA seek to acknowledge and quantify the progress made by the startup for the time period from its last Financing Round through the maturity date of the CLA should none of the mandatory conversion events occur during this time.
Once more, the advantage of setting in the CLA a fixed conversion price at the maturity date is that, by doing so, one should avoid potential disagreements if the startup reaches the maturity date without having yet realized a Financing Round or a Liquidity Event.
