The convertible loan as a PE instrument: opportunities, legal requirements and pitfalls

The convertible loan as a PE instrument: opportunities, legal requirements and pitfalls

In a market where valuations are under pressure, (re)financing rounds are taking longer to close and covenant breaches among mid-market portfolio companies are increasing, the convertible loan (Convertible Loan Agreement, hereinafter “CLA”) is appearing ever more frequently. A CLA is used where immediate equity or traditional debt is not an obvious fit, particularly in private equity transactions and restructurings, including in the start‑up and scale‑up space. This instrument can be attractive for shareholders seeking to limit immediate dilution and in situations where limited or volatile cash flow makes alternative debt solutions difficult. The choice for this instrument depends heavily on strategic considerations, including the cost of capital, control, and financial flexibility in terms of leverage. This blog explores the opportunities and pitfalls of the CLA in practice and the key legal requirements.

CLA and the hybrid position: creditor and future shareholder

A CLA gives the lender the right to convert a loan into shares at a later stage (including automatically, if agreed). The lender starts out as a creditor, but – subject to predetermined conversion conditions – may become a shareholder. This creates a hybrid position: downside protection through a receivable/claim, upside through conversion.

Clear conversion terms on price, timing and valuation are essential to avoid disputes about control and economic interests. From a control perspective, this includes matters such as voting rights, meeting rights, decision‑making and approval rights, and rights to nominate or appoint directors. From an economic perspective, matters such as dividend and reserve entitlements, pre‑emption rights on new issuances, and liquidation preferences (rights to liquidation proceeds) are key.

Until conversion, the investor receives interest on the loan, reducing risk compared to a direct equity investment (which typically bears no interest). However, the interest on a CLA is often lower than under a “plain vanilla” loan, as the conversion right offers additional value to the lender and compensates for potential return on equity. Interest is commonly rolled up and converted together with the loan – often around 4–5% per annum – frequently combined with a valuation cap (the maximum valuation at which the lender is prepared to convert the loan into shares) or a conversion discount (a discount on the price per share upon conversion).

Upon conversion, it must be determined what type (class) of shares will be issued. If a particular share class is envisaged that does not yet exist under the articles of association, a (timely) amendment to the articles and/or prior shareholder approval will be required. The conversion takes place through the issue of shares to the lender at the agreed conversion price, with the conversion price typically being satisfied by set‑off against the outstanding loan claim (including any rolled‑up interest). To the extent that the conversion price exceeds the nominal value of the shares, the excess is paid in as share premium (agio).

PE scenarios – when does a CLA provide a solution?

1.     Bridging finance ahead of a funding round

CLAs are often issued when a portfolio company requires additional funding but there is no prospect of a funding round in the near future. A CLA can be suitable where the company and/or investors wish to defer the valuation discussion to a later round, thereby limiting immediate burden and (often) immediate dilution. This can be particularly relevant where growth milestones have not yet been achieved.

2.     Refinancing and covenant breaches

A CLA can also be a structuring tool where a company comes under pressure. This may occur several years after a PE entry if growth falls short of expectations and covenant breaches become likely.

In practice, we see that in the event of refinancing or covenant breaches, lenders often request that existing shareholder loans be converted into shares or contractually subordinated, usually followed by an additional equity injection. This is a classic structuring request from lenders (including banks). This can facilitate negotiations, as the shareholder demonstrates that they are taking a risk and are not taking priority over external creditors. The reason for this is that, in the event of insolvency, shareholder loans rank pari passu (on an equal footing) with unsecured creditors, whilst lenders seek seniority in order to obtain priority in the event of enforcement. In addition, shareholder loans are treated as debt and therefore impact leverage and covenant rates such as the solvency ratio, debt-to-EBITDA ratio and interest coverage ratios. Conversion therefore directly improves leverage and covenant headroom. Subordination can help as well, but generally to a lesser extent. Furthermore, lenders also want shareholders to demonstrate commitment by “locking in” shareholder capital as non‑repayable. A repayable shareholder loan can create material liquidity risk because a shareholder could demand repayment at an unfavourable moment – weakening the cash position precisely when the lender’s exposure is highest.

3.      When the CLA is less relevant

In two scenarios the CLA can lose much of its practical value:

A.         Distressed situations – If the company is already in covenant breach or close to default, negotiated contractual rights can become secondary to security and enforcement dynamics.

B.         Multiple layers of subordination/consent – If conversion requires consent from a senior lender, a mezzanine lender and a banking syndicate, conversion may be economically unattractive before the process even begins.

No CLA structure can fully avoid this. In a genuine crisis, security will generally override contractual rights because it offers greater certainty and a better prospect of recovery. A CLA is an effective instrument only as long as the company remains a going concern – and those who recognise that in time, build structures that truly withstand stress.

Practical implications for PE parties – do’s and don’ts

On the one hand, CLAs are attractive because they offer speed and flexibility: the valuation discussion is deferred and the documentation and formalities are relatively limited, making a CLA a useful bridging instrument without immediate dilution. On the other hand, unclear conversion triggers can lead to disputes about the timing, price and valuation for conversion and dilution, with a risk of governance deadlock.

The importance of a well‑structured CLA should therefore not be underestimated. It is the instrument by which negotiating positions are fixed in advance. A well‑structured CLA should therefore, at a minimum, address the points below with sufficient clarity.

(1)     Conversion triggers: who can convert, when, and at what price? Common conversion triggers include the maturity date, a new funding round, achieving milestones, or a change of control. Parties may also agree what happens if an exit occurs before conversion. In an exit scenario, the lender may be entitled – alongside repayment of principal and interest – to (i) a multiple (for example 2x or 3x the loan amount) or (ii) pro rata participation in sale proceeds. It is essential to draft these triggers sharply and unambiguously to avoid disputes and legal uncertainty when they are engaged. A lender option to convert provides materially more strategic flexibility than automatic conversion on a third‑party trigger. It keeps control with the lender rather than giving it away.

(2)     Ranking and subordination: In a (re)financing, lenders will often require the CLA to be subordinated to the new and/or existing financing. Subordination does not have to be fatal for the CLA holder, but the value of its position depends heavily on the precise intercreditor arrangements on ranking, payments and enforcement. Subordination may mean the CLA holder is paid only after certain other creditors – such as a secured bank – have been satisfied in insolvency. The CLA holder’s leverage lies in the detail: if, despite subordination, it retains information rights, consent rights, default rights or conversion rights, the position may remain commercially workable. But where there are broad payment blocks, long standstills (periods during which a junior creditor may not, or may only to a limited extent, exercise its rights), turnover provisions and restrictions on material amendments without senior lender consent, the CLA can in practice become a passive junior claim. Where there are multiple CLA holders, it should also be agreed whether they rank equally among themselves or whether there is a further order of priority. Finally, it is important to specify clearly that the subordination is limited – for example, subordinated only to the bank facility or other specified financing – and does not constitute a general subordination.

(3)     Security: Security under a CLA is often underestimated. In practice, investors do not always give this explicit consideration, even though security can materially strengthen negotiating leverage. After all, as long as the loan has not been converted, the CLA investor remains a creditor and can use security or mortgage rights to secure a stronger (security) position, for example during restructurings. If the investor has negotiated security, it can deploy its hybrid position strategically by offering, for example, to subordinate the CLA and/or its security in favour of existing or new lenders. This can smooth negotiations while allowing the CLA holder to secure conversion economics, future participation or retention of upside. At the same time, security is temporary: upon conversion, the underlying debt claim falls away and with it the security (or, at least, the security no longer secures that claim). The CLA should therefore expressly stipulate what happens in cases of partial conversion, default, refinancing or sale. Finally, the timing of the creation of the security deserves attention. Security granted only when the company is already in financial difficulty can give rise to challenges on grounds including actio Pauliana (voidable transactions), selective preferential treatment, corporate benefit and existing negative pledge obligations towards the bank. For that reason, it is often sensible to incorporate the security package into the structure at the time the CLA is entered into.

The main pitfall is treating a CLA as a standard loan with a conversion clause. That misunderstands its function. A CLA is not a mere formality, but an allocation of control and economic interests between the shareholder, the company, the lender and other shareholders or investors.

Legal requirements for conversion: what not to overlook

For the share issue under a CLA, the following points require attention:

A.      Corporate Approvals: The decision to issue shares must be taken by the authorised corporate body in accordance with Dutch law and the articles of association. In a Dutch B.V., this is generally the general meeting of shareholders, although the power may also be attributed to another corporate body (by the articles of association or by resolution). When drafting the documentation, explicit attention should therefore be paid to which body is competent, what the articles of association provide and what corporate approvals are required.

B.      Pre‑emption rights: Existing shareholders generally have pre-emptive rights upon the issue of new shares. The CLA documentation must specify whether, and if so how, these pre-emptive rights are excluded or restricted, and the majority required to take such a decision. Investors typically stipulate a veto or a qualified majority to prevent undesirable dilution.

C.      Notarial deed: The issue of registered shares in a Dutch B.V. requires the execution of a notarial deed of issue. This deed formalises the share issue and may also stipulate that the subscription price is satisfied by set‑off against the claim under the convertible loan.

D.      Tax implications: The tax treatment of a CLA is often complex. It is therefore advisable to involve tax expertise at an early stage when entering into such an arrangement.

Ready to test your CLA structure?

For PE firms, now is the time to take a close look at where value and opportunities remain within a CLA.

Are you working on a (re)financing deal involving a CLA? Is an existing CLA in your portfolio under pressure? Or would you like advice on your current CLA structure?

DVDW advises PE firms, investors and management teams on setting up, negotiating and implementing CLA structures – from agreement to deed of execution. Please feel free to contact Daniel Osorno van Wissen or Simone Ronde.