Convertible Business Loan: 2022 Rules


The year 2021 brought a lot of interesting things in terms of new laws, and among them – changes in the law “On limited liability companies”, which established the rules for issuing a convertible loan.

I will avoid the use of the phrase “new rules”, because there were none before, there was only a generally accepted practice of processing through several documents: a corporate agreement, an option or a share pledge agreement, which led to a delay in the approval of all these documents and, as a result, the timing of the transaction …

At the very beginning after the adoption of the law, there were many fears and misunderstanding of how to apply it; lawyers found many limitations and disadvantages.

But after almost a year since the adoption of the law, the first transactions were made, and most of the questions disappeared. However, some drawbacks remain in the new design engine.

The essence of a convertible loan

The general meaning is as it was and remains: a convertible loan agreement allows you to provide an investor with financing for a startup and in the future to receive a share in the company upon the occurrence of certain conditions or simply after the expiration of the term specified in the agreement.

The undoubted plus for the investor is that now he has the right to choose: demand the return of the loan if the startup does not take off, or convert his loan into a share in the company if the startup grows.

As mentioned above, earlier such an opportunity had to be provided with options, which increased the paperwork and the costs of the parties for lawyers and notary costs, but now all the agreements of the parties can be drawn up in one document.

The adopted law allows the parties to settle disputes and guarantee the parties the observance of their rights, but many points are settled in an imperative form, that is, they do not give the parties the right to choose how to act in a particular case, but clearly indicate the procedure for action.

For example, the deadline for sending to the notary an application for the conversion of the investor’s share is clearly stipulated – 3 months from the date of the onset of the conditions specified in the agreement. Or the fact that now the information about the lender (potential investor) must be included by the notary in the Unified State Register of Legal Entities.

Given that an investor may not want to be a part of the startup, this moment may cause some investors to abandon the new mechanism if they do not want to publicly disclose their intentions ahead of schedule.

By the way, initially this moment gave rise to a lot of questions, criticism and even refusals of notaries to certify the convertible loan agreement, since the tax authorities did not develop the necessary form for displaying information in the Unified State Register of Legal Entities.

Now the problem has already been solved and the notaries enter the necessary data without any problems.

Rules for applying for a convertible loan in 2022

The registration scheme itself is very similar to the classic entry of an investor into a company through the application and acceptance of a third party as a participant, and it works as follows.

  • 1. A potential investor sends a statement to the startup to be invested on admission to the membership of the company and indicates in it that the contribution will be made by offsetting the claims under the loan agreement. It is also necessary to indicate the amount of the deposit, which is usually equal to the loan, and the required share.

All other conditions of the parties can be included in the contract at their own request. In practice, conditions are almost always included in the agreement, which are the so-called trigger points under which the investor can demand an early repayment of the loan or the necessary conditions for its conversion.

For instance:

  • Term. The simplest condition that the parties can fix in the contract. There is a binding to a certain date or the expiration of a certain period when the investor can choose to convert or repay the loan.
  • Qualified round. An indication of a certain amount of the round at which the conversion will take place.
  • In an unqualified round the parties can indicate that conversion is possible, loan repayment, the beginning of negotiations or, for example, conversion at a minimum estimate.
  • Divestment of assets, change of control. If, after receiving a loan, the startup sells its assets or the founders leave the company, then this is a reason for the investor to demand an early return of the money provided.

  • 2. The next step after receiving the application is to organize a general meeting of LLC participants., on which they give preliminary consent to conclude an agreement and increase the authorized capital at the expense of the investor’s contribution, which issues the loan. Such a decision must be notarized.
  • 3. After the approval of the loan, the parties enter into a loan agreement, which, like the decision, must be notarized. It is recommended to combine the second and third stages and notarize documents on the same day in order to optimize time and notary costs.
  • 4. Not later than two days after the conclusion of the contract, the notary submits an application to the IFTS with information that an agreement has been concluded between the investor and the company. Such a measure allows other potential investors to see that there are some restrictions in connection with the concluded loan agreement.
  • 5. After the investor decides to convert the loan into a share or the conditions specified in the agreement come true, he must submit to the notary an application for an increase in the authorized capital, after which the notary notifies the company of the received application from the lender, he must do this no later than the next day.

A small digression should be made and one thing should be said minus the convertible loan: lack of complete automatism. That is, if the founders of the startup do not want to convert, they can file objections to the notary, and the investor will have to go to court to convert their money into a share. Considering that the trial can last 1-1.5 years, the prospects are not the best.

It is unlikely that such situations will arise often, because due to such a dispute it will be difficult for a startup to raise money in the future, but the very fact of the possibility of delaying the conversion may alienate some investors.

  • 6. After receiving notification from the notary the startup borrower has 14 days to file an objection to the investor’s application for the share conversion.

Some problems have not yet been resolved here:

a) how are objections sent? In simple writing or through a notary?

b) if objections are sent in a simple written form, then there may be an obvious delay in the deadlines: the company will send its objections to the notary on the last (13th) day by mail, which will be quite legitimate, but will drag out the deadline for investors and the notary.

In conclusion, the following pros and cons of structuring a deal using a convertible loan can be highlighted:

Minuses:

  • there is no way to force the company to convert money into a share without a trial;
  • it is necessary to organize a meeting of participants to approve a convertible loan and certify the contract with a notary, as opposed to issuing a loan according to the old procedure;
  • the issue of what to do if during the validity of the loan agreement another participant enters and the ratio of the participants’ shares or the authorized capital changes;
  • unanimous approval of all company participants is required (in companies with several participants this can be difficult and will significantly reduce the speed of application of the tool).
Pros:
  • automatic conversion of money into a share in the absence of a dispute;
  • an increased guarantee of converting money into a share (even if you have to go to court) compared to earlier designs;
  • upon transfer of rights under a convertible loan agreement, the new lender is not entitled to demand conversion. This is a big plus, because for a startup, the personality of the investor can play a significant role, and this situation will not allow a dubious person to enter the membership.

The new law is not the most ideal, but nevertheless it makes life a little easier for investors and allows, without excluding the framework of the law, previously used structures, to structure venture capital transactions using a legal and reliable mechanism, and all its disadvantages will sooner or later be corrected by the legislator or judicial practice.

Will the old scheme work?

Of course, after all, in the Law “On Limited Liability Companies” there are still provisions stating that mutual claims can be offset against the investor’s contribution, and therefore no one can prohibit drawing up a loan agreement in a simple written form and then offsetting mutual claims between investor and startup.


Cover photo: Shutterstock / only_kim


Source: RB.RU by rb.ru.

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