This is the second part of a series of articles on SME Business. In this article, we will discuss when and why you should be raising convertible debt for your Singapore business. We will also highlight some key commercial terms that you need to understand when commencing negotiations for funding.
Business owners raised convertible loans when they do not want to give up equity to the investor at the point of funding as they envisage: (i) they can repay the investor at the end of the loan: or (ii) they ascertain at the point of funding that they cannot agree on the valuation of the company at the point of funding which is the reason why a priced equity funding round was not carried out.
What is a convertible loan?
Most businesses are familiar with a loan from a bank but are less familiar with a convertible loan. For companies that have not maxed out your debt to equity ratio or loan to value ratio with your existing bank you may want to consider raising funds via a convertible loan from a growth private equity firm.
A convertible loan is basically a debt instrument with an option for the lender to convert his debt into equity in your firm.
Why investors invest via a convertible loan?
From the investor’s point of view, they prefer to invest via debt rather than equity if they ascertain that from a risk point of view, investing in your firm at the particular point in time is risky or if the business owner and the investor are unable to agree on a fixed valuation for a priced round.
On the other hand, there are some private equity firms that do growth capital investing, i.e. they invest small amounts in companies and help the company grow larger and then exit (either by the investee company repaying the loan with interest or via a trade sale/IPO (whereupon, they convert the convertible loan into shares to get the upside)). Growth private equity firms take small minority stakes in companies and work with them to grow larger. Most growth private equity firms usually have internal targeted returns of 20% to 25% for their investors so usually they will invest in your company via a mixture of convertible debt with an interest of between 10% to 15% and warrants (which may give them the difference in the return if there is a trade sale/exit event). This is in comparison with leverage buyout private equity firms that acquire controlling stakes in mature firms and help them grow larger and then sell them to potential buyers.
Key terms to negotiate in a convertible loan agreement
Term of the Loan: Like any loan agreement, the borrower needs to ascertain what is the term of the loan, i.e. when is the principle due.
Interest rate: The borrower should negotiate the interest rate. Obviously the lower the better, but it cannot be below what the lender needs to get for their investors.
Repayment schedule: The borrower should also send some time doing internal financial cash-flow modelling to ascertain its repayment ability to see if it should take the convertible loan. Obviously, if the borrower cannot service its loan (based on the interest charged and the terms and conditions of the convertible loan when taken in totality), the borrower should never enter into such a convertible loan.
Conversion formula: This is the most complex part of the business that needs to be negotiated. Do spend some time modelling the worse-case scenario, base-case scenario and best-case scenario in the context of dilution to founders of the business. If in doubt, hire an accounting/corporate finance/investment banking trained person to look at the conversion formulas. You should also engage a corporate lawyer to help you study this provision in detail.
Key terms to negotiate in a Warrant Deed
In some funding deals, the investor will enter into a warrant deed (in addition to the convertible loan). In this structure, you would need to figure out how the warrants convert into equity. The same conversion formula analysis (as set out in the convertible loan) will be applicable.
Conversion formula: This is the most complex part of the business that needs to be negotiated. Do spend some time modelling the worse-case scenario, base-case scenario and best-case scenario in the context of dilution to founders of the business. If in doubt, hire an accounting/corporate finance/investment banking trained person to look at the conversion formulas. You should also engage a corporate lawyer to help you study this provision in detail.
In conclusion, negotiating a convertible loan funding deal with an investor is a complex matter and you would do well to engage a good corporate lawyer in Singapore to study the key commercial points of your funding deal and advise you accordingly. If you are looking for funding without the need for immediate equity dilution with the possibility that your business will do better some time later, a convertible loan funding deal may be the right thing for you. We wish you all the best in your business and growth going forward.
https://www.SingaporeLegalPractice.com is a corporate law and commercial law educational website headquartered in Singapore which aims to demystify business law and 新加坡商业法 for SME Company Owners, Startup Founders and 新加坡新移民老板。The information provided on this website does not constitute legal advice. Please obtain specific legal advice from a lawyer before taking any legal action. Although we try our best to ensure the accuracy of the information on this website, you rely on it at your own risk. Click here to signup for our newsletter today to be kept updated on the latest legal developments in Singapore.
Click here to speak to a specialist Corporate Law Practitioner today to advise you on your corporate transaction today. The corporate law team has acted for a diversified client base including transactions involving several hundred startups across the startup eco-system in Singapore and for private equity fund deals and is well placed to help you in your corporate transactions.
Signup for our website newsletter to be updated on the latest in Singapore law!
