Convertible debt: 5 key questions for private companies and investors


We have seen a number of private companies issue and invest in convertible debt securities in recent months. In this blog, we explore the trend by looking at 5 key questions for private, unlisted companies and their investors to consider.

1. What is a convertible debt security?

Typically, it is a loan, bond, or lending security that gives the lender/holder the right to convert their right to receive repayment of the instrument into newly issued shares of the borrower/issuer.

2. Who issues the convertible debt?

Convertible debt securities are a flexible way for new businesses to raise the funds they need to grow their business. Startups with a short track record and limited capital can use convertible debt instruments to bridge into an equity funding round, for example.

Similarly, smaller, more established businesses embarking on a period of growth or a new venture could use convertible debt as a way to tap into new sources of funding when they lack the appetite to issue debt. shares.

3. How do they work?

The convertible debt instrument will have many of the characteristics of a typical loan or bond, for example:

  • specified procedures for drawing the loan/issuing the bond.
  • interest accrues and is payable on certain dates.
  • a final redemption date for the full redemption of the instrument at maturity.
  • representations, pacts and commitments.

In addition, it will have a few other characteristics specific to a convertible instrument, such as:

  • a right, exercisable by the lender/holder under certain circumstances or during a specified period, to convert the instrument into shares (at a specified price or at a specified percentage of the equity then outstanding), or an obligation (rather than a right) for the lender/holder to convert the instrument into equity in certain cases or after a certain time.
  • certain specified events that trigger redemption rather than conversion – such as insolvency, change of control or disposal of substantially all of the assets of the issuing/borrowing entity.

4. What’s in it for the borrower/issuer?

The establishment of a convertible instrument may, depending on the applicable company law of its place of incorporation, be faster than the issuance of new shares, which may be associated with a process defined in the articles of the company (although that in many jurisdictions such as the UK, extending a stock option in the future would require approvals to be in place when the instrument is issued).

The participants in the operation must also take into account the pre-emption rights in applicable company law and in any shareholders’ agreement.

Issuance of new shares may also involve substantial documentation or may require the consent of other investors (although sometimes a convertible instrument will also require the consent of external lenders and often will also require the consent of some form of the base of existing shareholders).

A convertible instrument is a bilateral agreement between the borrower/issuer and the lender/holder that can usually be agreed more quickly, so it can be a quick and efficient way to raise funds.

Generally, convertible debt will be cheaper than conventional debt because of the conversion rights attached to it.

Finally, as the lender/holder will not have voting rights until conversion (although many instruments offer them some form of minority protection and often attempt to treat them as deferred or contingent shareholders prior to conversion ), this reduces its influence on the borrower/issuer.

5. What’s in it for the investor?

Before conversion, the lender/holder benefits from the advantages of a debt investment, such as:

  • a claim on a convertible debt instrument is debt and will therefore rank ahead of equity in the event of the insolvency of the borrower/issuer.
  • the lender/holder may have the right to require redemption of the instrument in cash in certain circumstances (which will be negotiated) that an equity investor would not have.
  • as an early investor in the borrower/issuer, the lender/holder’s conversion right is likely to be discounted (compared to public convertible markets where conversion would always be above current market value).

Following the conversion, the lender/holder benefits from the advantages of equity, for example:

  • the right to vote at general meetings.
  • the right to receive dividends.
  • benefit from any increase in the share price over time.

For these reasons, a convertible instrument is sometimes an appropriate way to invest in a business or for a business to raise funds. If you are considering a convertible instrument, or have questions about the points covered in this blog, please contact one of the authors.

Our Transactions The page includes additional blog posts and information about deals you might consider.

This material is provided for general information only and is not intended to provide legal advice.

This blog is current as of May 30, 2022.

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