What is a convertible loan?
At an early stage, it can be difficult to determine a company’s precise value. A company may therefore receive money as a loan and later, instead of returning all or part of the principal and/or paying interest, grant the lender an equity interest or issue and place shares in the lender’s favour.
Signing the agreement and transferring the money do not automatically make the lender a member or shareholder. That status arises after the required corporate actions and the relevant entry in the state register or shareholders’ register.
The conversion option must be included when the agreement is made. Certain regulated financial organisations may be subject to additional restrictions.
How the mechanism works
Before conversion, the lender generally has no statutory voting, dividend or management rights as a member or shareholder. The agreement may grant information and other contractual rights.
- 01Agreement and funding: the lender is a creditor and the company owes repayment under the agreed terms.
- 02Conversion trigger: the agreed event occurs or the lender submits a request/application.
- 03Corporate formalities: the company adopts the required resolutions and, where needed, updates its charter and registration data.
- 04Conversion or repayment: the lender receives an interest/shares, or the repayment terms apply if conversion does not occur.
What the agreement should define clearly
The agreement should set out a clear, testable conversion mechanism, including:
- the amount, currency, funding method and possible tranches
- whether interest applies, how it is calculated and whether it converts
- the event or process that triggers conversion
- the amount to be converted and the formula for determining the interest or number of shares
- a fixed valuation, valuation cap or discount to the next investment price
- the consequences if conversion does not occur, and what happens on a sale, change of control, liquidation or insolvency
- security, corporate approvals, charter amendments and registration steps.
Written form and interest
If the loan is interest-free, the agreement should say so expressly. As a general rule, the lender is entitled to interest unless the parties agree otherwise, and the rate and calculation method should be clear.
The loan agreement must be in writing. Keep bank records or other evidence of the transfer: the loan is considered concluded when the money or other property is transferred. Failure to comply with the written-form requirement may make the agreement invalid.
Conversion in an LLC
All members must unanimously approve the conclusion of a convertible-loan agreement and amendments to it. At the conversion stage, the lender submits an application to the executive body.
If the lender is already a member, conversion may increase the nominal value of that member’s interest. If not, the company must decide to admit the lender, increase its charter capital and grant the relevant interest.
When the statutory conditions and application are present, the necessary decisions must be made within 60 days, followed by the required charter and registration updates.
Conversion in a joint-stock company
The company issues and places the agreed type, class and number of shares in favour of the lender. These shares generally need to fit within the authorised shares and nominal-value limits in the charter.
The agreement is approved unanimously by all voting shareholders unless the charter sets a threshold of at least three quarters of the votes. Where that threshold applies, a dissenting shareholder may have a statutory pre-emptive right.
After the written conversion request is received—or deemed received under the agreement—the company must issue and place the shares within 60 days if the conversion conditions are met.
If the loan is in a foreign currency
The conversion amount is calculated in Armenian drams using the average market exchange rate published by the Central Bank for the date on which the conversion request/application is received or deemed received.
On that date the foreign-currency loan is replaced with a dram-denominated loan under the statutory mechanism. The exchange-rate date and calculation formula therefore deserve special attention because they can change the conversion amount and the final participation.
Advantages of a convertible loan
For the company
- The valuation can be postponed until more financial information is available.
- Funding can sometimes be arranged faster than a full equity investment.
- There is usually no immediate dilution before conversion.
- The lender’s interests can become aligned with the company’s future growth.
For the lender
- The lender initially has a monetary claim against the company.
- If the company grows successfully, the lender may receive an interest or shares on agreed terms.
- A valuation cap, discount or fixed formula can make the future price more predictable.
- If agreed, the lender may choose between repayment and conversion.
Risks and consequences
The instrument works best when its terms are balanced and precise. Key risks include:
- dilution of existing members’ or shareholders’ interests and a change in management influence
- a future repayment obligation if conversion does not happen
- an illiquid and non-guaranteed asset for the lender
- disputes over the amount, percentage or number of shares because of an unclear formula
- delays caused by corporate or registration failures
- foreign-exchange effects on the conversion amount
- additional tax and accounting consequences depending on the parties and deal structure.
A simple example
A company receives a convertible loan of USD 100,000. If it raises a new investment, the lender may convert the principal and, if agreed, accrued interest into an equity interest at a discount to the new investment price. If the event does not occur by the final date, the agreement may provide for repayment, a conversion right or the lender’s choice.
The final interest depends not only on the USD 100,000, but also on the formula, the company’s value at conversion, the exchange rate and the required corporate and registration steps.
Conclusion
A convertible loan can be effective for start-ups, fast-growing companies and businesses raising investment. It combines the flexibility of a loan with the possibility of future participation in the company’s capital.
Its outcome depends on the agreement’s quality. The conversion event, formula, currency treatment, party rights, corporate approvals and default consequences should be defined in advance and without ambiguity.
FIAK · Support
A convertible loan with the right structure
FIAK’s legal team can help choose the deal structure, prepare the agreement, balance the company’s and investor’s interests, and organise the required corporate and registration steps.
Request a consultationThis article is general information and does not replace individual legal, tax or accounting advice for a specific transaction.
