| Artículo | Junio 2021 | Convertible loans granted to Spanish non-listed companies: key features |
The most common sources of financing for Spanish non-listed companies are equity invested by shareholders and bank financing. Direct lending has also become increasingly popular. Over the last decade, however, a number of convertible loans have also been granted. The purpose of this article is to shed some light on this trend, which is linked to the Spanish M&A market, rather than the Spanish debt market, as well as the granting of convertible loans by potential investors or pre-existing shareholders of non-listed companies, which can be either repaid in cash or capitalised in exchange for newly issued shares of the borrower, in certain scenarios.
What is a convertible loan?
A convertible loan is a financing agreement by virtue of which a lender, typically a venture capital firm, a private equity player or a strategic investor, lends to a company an amount for the purpose set forth in the agreement. The lender is normally a third party which is not a shareholder of the borrower, even though convertible loans can also be granted by pre-existing shareholders. The borrower is the company which undertakes to use the loan for the purpose indicated in the loan agreement and to repay the principal, interests and applicable costs.
Each convertible loan is tailored to the specific needs of the parties and the circumstances of the case at hand, but there are a number of issues which should be highlighted. First, the main particularity of a convertible loan is that the principal, interests and costs (if any) can be capitalised in exchange for newly issued shares of the borrower. Second, the principal is usually due on maturity, as a bullet payment. Third, ordinary interest, although it accrues daily, becomes payable upon maturity. In certain transactions, accrued interest becomes payable every six months or on a yearly basis, but payment upon maturity is very common. Interest rates tend to be much higher than in the bank lending market, as the risk assumed by the lender is typically higher. Fourth, convertible loans are usually unsecured, as such no personal or in rem security is granted in favour of the lender. Finally, the conversion price is regulated in detail. The number of shares to be issued, as well as the nominal value and the share premium of these shares, must be clearly determined.
To what kind of companies are convertible loans granted? And in what context?
Most convertible loans are granted to fast-growing companies, mainly start-ups. Companies enduring financial difficulties or those which are perceived as a risky investment also qualify for convertible loan financing.
The size of the convertible loans granted over the last decade is directly related to the size of the target, namely, the borrower, from a few hundred thousand euros to hundreds of millions. In other words, there have been significant convertible loan deals in recent years, involving several financial and corporate players and industries.
This type of loan is granted when the target has liquidity needs that cannot be covered with pre-existing equity and the ordinary cash flows generated by its business. The liquidity needs financed through convertible loans varies from case to case; for example, funding ordinary business activities or funding a very specific investment are common purposes of convertible loans. Companies that look for this kind of financing typically do not qualify for bank lending, either because their financial track record is not solid enough, because their business plan is perceived as being far too risky or because bank lending does not fit for other reasons.
From the lender’s perspective, granting a convertible loan to a company has certain advantages compared to a direct equity investment. First, the lender has much more time to ascertain whether it is really worth investing in the target and, therefore, assuming the additional risk that an equity investment entails. Second, holding an ordinary credit right against the borrower, instead of a subordinated credit right, is relevant in the context of a potential insolvency of the borrower. However, if the loan is granted by a pre-existing shareholder of the borrower holding at least 10 percent of its share capital, the loan would qualify as subordinated according to Royal Legislative Decree 1/2020, of 5 May, approving the consolidated text of the Insolvency Law.
Conversion into equity
A crucial aspect of convertible loans is the regulation of the scenarios under which the loan can be converted into equity of the borrower (i.e., capitalised by the lender). Although each situation is different and the parties are free to include the trigger events that they deem appropriate, the following are the three scenarios in which a right to convert is normally included in convertible loan agreements.
Repayment upon maturity. The loan shall be repaid upon maturity, at the lender’s option, in cash or by issuing shares of the borrower in exchange for the contribution of the lender of the receivable corresponding to the amounts due and payable under the loan. As a result, the borrower has the obligation to repay the loan in cash, but the lender has the right to either capitalise the loan in exchange for newly issued shares of the borrower or to ask for a cash repayment.
Repayment upon financing. As the potential aim of the lender is to end up participating in the share capital of the borrower, based on the shareholding structure as of the date of the execution of the convertible loan agreement, it is common to include the following mandatory prepayment situations: the issuance of new shares in the borrower and the execution of additional convertible loans or the assumption of any other undertakings to issue shares, options over shares or any similar or related instruments. In case any of these mandatory prepayment situations occur, the borrower has the obligation to prepay the loan in cash, but the lender has the right to capitalise the loan in exchange for newly issued shares of the borrower.
Repayment upon a liquidity event. The approval of an initial public offering (IPO) or an M&A transaction entailing the transfer of all or a significant portion of the borrower’s shares, assets or businesses are situations that normally trigger mandatory prepayment of the loan as well. In the event of any of these situations occurring, the borrower has an obligation to prepay the loan in cash, but the lender has the right to capitalise the loan in exchange for newly issued shares of the borrower prior to the implementation of any of these transactions.
The conversion is structured as a share capital increase of the borrower in which new shares are issued in exchange for the contribution of the lender of the receivable corresponding to the amounts due and payable under the loan at the time, such as outstanding principal, accrued and outstanding interest plus accrued and outstanding costs, if any. According to Royal Legislative Decree 1/2010, of 2 July, approving the consolidated text of the Companies Law, a receivable must be fully liquid, due and payable in order to be contributed in exchange for newly issued shares of a Spanish private limited liability company, which is by far the most common non-listed company type in Spain. In the case of Spanish public limited companies, at least 25 percent of the receivable must be fully liquid, due and payable in order to be contributed in exchange for newly issued shares, and the remaining part of the receivable must become fully liquid, due and payable within the following five years. Spanish public limited companies are a minority company type among non-listed companies.
Corporate approvals required for the execution of a convertible loan
From a Spanish corporate law standpoint, the execution of a convertible loan agreement by the borrower company does not include the issuance of shares or any other equity instruments. Rather, the mere execution of a convertible loan agreement has no direct impact on the existing shares and the borrower’s share capital.
Generally, execution of a convertible loan requires a resolution of the general shareholders’ meeting of the borrower. The board of directors, or the applicable management body in each case, as Spanish companies do not necessarily have to be managed by a board of directors, can be vested with the authority to approve convertible loans, but the general practice is not for the board of a non-listed company to resolve these matters.
It should be noted that the conversion of the loan into equity requires a resolution of the general shareholders’ meeting in order to approve the relevant share capital increase. In other words, the conversion is not automatic, and requires a favourable vote of the majority set forth in the by-laws of the company for approving share capital increases. Consequently, it is crucial that the convertible loan includes binding commitments from the borrower’s shareholders (or, at least, of shareholders holding sufficient voting rights for the approval of the future share capital increase) to vote in favour of the conversion when the time comes. These shareholders’ commitments can be documented in the convertible loan agreement or in separate letters or agreements.
A reference to minority shareholders of the borrower company
It may occur that minority shareholders (whose vote is not necessary to approve the convertible loan and its conversion into equity) are not aligned with majority shareholders, either because they believe that the execution of the convertible loan is not appropriate or necessary for the borrower or because they consider the conversion price to be unfair – be it too low, and therefore detrimental to their interests as shareholders, as they will end up more diluted than necessary with a market conversion price, or for other reasons.
According to the Companies Law, corporate resolutions that are contrary to law, the by-laws, the regulations of the general shareholders’ meeting or detrimental to the corporate interest to the benefit of one or various shareholders or of third parties can be challenged. A detriment to the corporate interest is also caused when the corporate resolution, without causing damage to corporate assets, is imposed in an abusive manner by the majority shareholders. A corporate resolution is understood to have been imposed in an abusive manner when, rather than responding reasonably to a corporate need, the majority adopts the resolution in their own interests and to the unjustifiable detriment of the other shareholders. The Spanish Supreme Court has issued various rulings on share capital increases successfully challenged by minority shareholders that are deemed to have been imposed in an abusive manner by majority shareholders.
Any potential discrepancies among shareholders must be carefully analysed on a case-by-case basis, as minority shareholders have the legal mechanisms to challenge the execution of a convertible loan and its conversion under certain circumstances.
Convertible loans vs profit participation loans
It is worth clarifying that convertible loans can be structured as profit participation loans (PPLs), but they are typically not.
Under Spanish law, a PPL is, in summary, a loan with a variable interest linked to the performance of the borrower, such as net profit, total income or any other concept agreed between lender and borrower. PPLs can also have a fixed interest.
A big advantage for borrowers is that PPLs are deemed equity for capital impairment tests set out in the Spanish Companies Law, but a disadvantage for the lenders is that PPLs are subordinated in insolvency scenarios. As a result, lenders that are interested in a potential investment in a company through a convertible loan do not have, as a rule, an incentive to structure the loan as a PPL.