The financing of start-ups, enterprises in the seed stage, and medium-sized businesses has changed significantly over time, giving investors several investment structuring alternatives based on the financial health and organisational structure of the target business. For various reasons, including the value of the target business and cost-effectiveness, businesses and investors prefer to raise capital using convertible loan notes (CLN) rather than standard equity and debt investment structures during early-stage rounds. CLNs are distinct from other loan note structures in that they can be converted to equity on the occurrence of a conversion event. Parties have numerous conversion event structures at their disposal, depending on the objectives that the investor and the target business hope to achieve. In this article, we explore the CLN model and the various factors that one should keep in mind when drafting a CLN.

Why the CLN?

First, it is important to understand the purpose of the CLN before deciding how, if and when the loan will be converted. There are times when a target firm is cash-strapped and decides to request a loan in the form of a CLN from a third-party investor or an existing shareholder (the Lender), to temporarily resolve its cash flow requirements. Using a CLN may be a quick method for the Lender to guarantee its return without having to go through a due diligence exercise which, in any case, could be lengthy, and which could result in protracted negotiations over transaction documentation. Entering into a CLN ensures that once the loan has been disbursed, if converting to equity is unappealing, the Lender is able to choose repayment over conversion.

As an alternative, Lenders may choose a CLN because it simply gives them more security. After all, if the target business cannot repay the loan, the Lender has the option of becoming a shareholder and transforming the business rather than having to liquidate assets (which the target business may not have) to recoup its investment.

A Lender may also decide to enter into a CLN when unsure of the company’s future performance and, therefore, may choose to stagger its investment into the target business.

Conversion

A CLN essentially gives the Lender and the target business flexibility to meet their needs. The following are some considerations for both parties:

a) Maturity date: the parties will agree on a date by which the loan will mature, known as the maturity date. On this date, depending on the negotiating power of each, the parties can decide if the loan automatically converts, whether the Lender has the option to convert or whether the right of repayment accrues. If acting for the company, the effect of increasing the shareholding, seeking shareholder approval, and potential dilution of the shareholders versus the interest payable on the loan will be key considerations.

b) Equity financing round: if the valuation of the target business is of concern, an equity financing round should be considered as a conversion event by the Lender. An equity financing round is essentially the process of raising capital through the sale or issuance of shares. Depending on the industry of the target business, different parameters can be set by the Lender and the company to the equity financing round. The parameters can be pegged on the number of Lenders participating in the equity financing round or the amount that is raised in the equity financing round. Given how the target firm is valued, the Lender should provide itself with a solution that offers it more security in its investment.

c) Change of control event: the exercise of control over the target business is an element that can be considered as a conversion event. The Lender can opt to convert the loan to equity on the occurrence of a merger, amalgamation, restructuring, sale of assets or execution of an agreement that gives a person or an entity significant control. This option provides the Lender with the flexibility to discern whether they should convert depending on how the company evolves.

d) Event of default: these include events that would ideally result in the termination of the CLN, such as misrepresentation, insolvency, material adverse change, and breach of representations and warranties. On the occurrence of the event, the Lender can opt to terminate the CLN and demand immediate repayment or convert the loan to equity. When negotiating the events of default, the factors to be taken into consideration by both the Lender and company is the nature of the business and the operating values of the Lender; for example, anti-money laundering considerations and the undertakings provided by both parties within the CLN. Essentially, the parties should consider the elements that are non-negotiable.

The value of the loan upon disbursement and the value upon repayment or conversion are additional factors to take into account when deciding whether to convert or demand repayment, specifically:
a) what is the interest chargeable? Is it per annum? Is it cumulative? Does it accrue until full repayment has been made or conversion has occurred?; and
b) the number and value of shares to be issued. Is it a set number of shares? Will a valuation need to be conducted? If so, what are the parameters? Will the target business and Lender benefit from a valuation cap or a discount?

These provisions need to be carefully thought out and should be well articulated and clearly drafted in the CLN.

Food for thought

Despite the benefits of a CLN, which include having the security of acquiring equity, debt ranking higher than equity in the event that a company becomes insolvent and allowing the target business to maintain its shareholding while obtaining financing, the primary risk emanates from ambiguity arising from a poorly drafted CLN.

Given the nature of companies seeking loans in the form of CLNs, the underlying risk is exponential. As most companies are generally in their formative stages, the uncertainty of success should be a concern to negate in the CLN. To counter the risks, the Lender and the company need to consider the purpose of the CLN vis a vis their goals, and accurately structure it to protect themselves against foreseeable risk.

Notably, the CLN has grown in popularity as a result of its adaptability and lack of regulatory requirements for structuring. Although we anticipate that the CLN will provide target businesses with loans at lower interest rates, poor drafting and structuring could result in a deadlock between the Lender and the target business. In this respect, we advise that careful thought be given to the structure of the CLN based on the needs and goals of the target business and the Lender.

Njeri Wagacha is a Partner and Rizichi Kashero-Ondego a Senior Associate | CDH Kenya

This article first appeared in DealMakers AFRICA, the continent’s quarterly M&A publication.

DealMakers AFRICA is a quarterly M&A publication
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