Convertible loan: What should founders consider in the first M&A deal?

Often, at the early stages of a startup's development, investors do not enter the business immediately but choose an alternative way: the investor lends funds, and in the future (if things go well), the company undertakes to convert its debt to the investor into a share in the share capital. Such transactions are usually structured with a convertible loan agreement. Let's use the example of such an agreement to see what to look for when negotiating the terms of an early M&A deal.

1. Convertible loan may need to be repaid

In general, a convertible loan scheme provides that the investor can either request conversion into a share or request the money back (for example, if they decide they do not want to participate in the business).

We recommend considering a SAFE (Simple Agreement for Future Equity) instead of a convertible loan if you are unprepared for such a turn of events. It differs from the former by having clear triggers when the conversion or payment to the investor occurs (mainly a new investment round). If the trigger does not occur, you do not owe the investor anything. Such an agreement is a less favorable option for the investor, but it is still quite common.

2. Conversion percentage

This is the main point and should be approached with the utmost attention. It determines how much business the investor can obtain from entering the agreement. In this case, it is essential to realize that issuing shares to the investor will reduce (dilute) the existing shares of the founders.

3. Trigger events

Another crucial point is the triggering events, upon which the investor may request conversion of the loan amount into shares (or its repayment). Standard triggers include a new investment round, the sale of the business to a new buyer, IPO, etc.

Here, it is crucial to draft such triggers as clearly as possible to avoid a situation where, for example, a technical reallocation of stakes between founders would convert the investor's loan into a share. In addition, it is not the safest option for the founder when the investor can convert the loan at any time and at its discretion. It is recommended to avoid such a situation.

4. Investor’s control

A standard convertible loan provides for a delayed entry of the investor as a shareholder (usually to the next investment round). Until then, the founders retain the freedom to manage the business as they see fit.

At the same time, the investor's desire to know what is going on in the company is completely understandable, which is why you can often find in the agreement the investor's right to receive information from the company (about revenue, expenses, negotiations with new investors, current problems, etc.). This is standard practice, but ensure that the list of such information is adequate, its provision is not too burdensome, and will not interfere with ordinary business conduct.

Sometimes, investors, even before receiving shares in the company, already desire to participate in its management along with the founders and ask for veto rights on certain business decisions (up to the point of attracting a new investment round) or pre-emptive rights to acquire shares. Such situations are not relatively standard.

It is up to you whether you agree to this or not. We recommend that you approach this issue very carefully, assess all the conditions (especially regarding the transaction amount), and determine whether you are ready for such terms. In any case, you can try to limit or narrow such rights of the investor.

5. Involvement

Since the investor is interested in having the founders focus on the startup, the investor may include in the agreement non-competition obligations (obligations not to develop or be involved in similar businesses in parallel). This is a normal condition for such deals. However, the founder may consider a mirror non-solicitation obligation – a commitment by the investor not to solicit the startup's team.

6. Representations and warranties (we have already written so much about them)

Often, investors ask founders to provide representations and warranties that all the intellectual property rights to the company's product are properly and fully vested in the company. This is often a weak point for a startup, as internal processes have not yet been established, not all those engaged individuals have formalized relations with the company, etc. There is no need to confirm inaccurate representations and warranties because the negative consequences may follow. It is better to disclose to the investor all the outstanding issues and jointly work out the way to correct them.

7. Sanctions

In general, you should carefully review the document to see the obligations imposed on the founders. Here, it would help if you avoided vague wording that does not give you an idea of what the investor expects from you. For example, the obligation to make every effort to develop the business: your efforts may seem sufficient to you but not to the investor.

Another crucial point is that liability must be commensurate with the breach. Incommensurate liability is when a breach of the “involvement in the business” obligation is punishable by transferring all the rights to your product to the investor. This is something we strongly recommend avoiding.

Understandably, you want to close the deal, get the money, and start developing your business as soon as possible. However, do not underestimate the importance of agreeing on all the terms and conditions because the consequences can sometimes be very unfavorable, up to and including the loss of business. Therefore, we recommend that you take your time in this matter and carefully approach the negotiation of the transaction documents.

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