Obtaining financing is often one of the biggest challenges for early-stage entrepreneurial ventures (startups). In search of alternative ways to obtain capital, many startups turn to financing through “convertible debt” (convertible debts), which gives the financier the opportunity to later convert his debt to the company into shares/units. In this context, the transformation of debt into social capital stands out as a way by which a company’s debts can be transformed into real opportunities for its development.

The legal mechanism briefly described above has originsAnglo-Saxon known as “debt-for-equity swap“. In Romanian legislation, it has advantages over direct regulation: Art. 210 of Law No. 31/1990 on companies provides for this as a way of increasing social capitalby indemnifying certain, liquid and legal claims against the company with its shares/shares.

This method of financing involves the creditor in the development of the company and gives him a direct interest in the development and implementation of the business project. It is for this reason that the tool is often used by certain categories of financiers/investors, for example “business angelus” or venture capital investors (“venture capital investors“). The risk in such a situation is high: the failure of the entrepreneurial project leads to the impossibility of returning the investment, since there are usually no other guarantees.

We clarify that in other forms of financing, such as banking, the mechanism of converting debt into shares is not used in principle. The bank will not be interested in converting its (guaranteed) claim into simple social shares (becoming a simple social creditor), since it will lose its mortgage right and/or other guarantees related to the claim.

A practical example. X SRL, an IT startup, needs funding for software development. The investor notices the potential of the business project and provides a loan of 10,000 lei along with an agreement on the future conversion of own debt into social shares.

In the given example, a claim of 10,000 lei can be converted as such, and the social capital will be increased by the entire borrowed amount. If this is the case, then it is obvious that the other associated companies will be “diluted” disproportionately: if the company’s share capital was 100 lei until now, the creditor will acquire almost the majority of the shares, to the detriment of the existing partners. It is for this reason that the conversion of the claim will not, as a rule, be carried out into shares with an equivalent nominal value, but at a lower value: for example, the entire claim of 10,000 lei will be converted into only 50 shares with a nominal value of 1 lei each.

The difference between the actual debt and the nominal value of social shares will represent first release, which are provided to the company to finance the projects in which it participates. Therefore, the share premium is a tool to protect the remaining shareholders/associates from dilution of their shares/shares.

Possibilities of debt conversion financing

In practice, the mechanism of converting debt into authorized capital occurs in two situations:

1. When at the time of financing, the creditor did not intend to convert its claim and become an associate/shareholder. Subsequently, the creditor determines the real opportunities for the development of the company, correspondingly, a greater benefit if it had the status of an associated person (through the prism of received dividends). As a rule, the company is in a “crisis” of liquidity, not being able to repay the loan taken. In the conditions of this “crisis”, the creditor will receive shares/shares at a much better price than other partners/shareholders.

2. When, from the moment of financing, the creditor has assumed the right to convert his claim and become the next partner/shareholder. This contractual configuration is called “Convertible loan agreement“.

There are many advantages to convertible debt: offers the option of charging interest by the creditor, so that at the time of conversion the creditor requires converting a larger claim (capital plus interest) into a larger number of social shares. It is also possible to highlight advantages for the company itself – for example, convertible debt postpones the valuation of shares. If an investor bought social shares directly, their value would become the first reference point for other investors. However, it is possible that the company is interested in being evaluated later, with the development of the business project and the strengthening of the trust and image of the company.

Disadvantage of convertible debt it is the very fact that they have the nature of debts: from a financial and accounting point of view, the company appears to be in debt to creditors.

Finally, many companies turn to this financing mechanism because it provides a number of advantages: first, the company will have more chances for recovery / development.Debt-to-equity conversion increases the company’s liquidity, providing it with additional resources for investment, expansion and development. This aspect is inextricably linked with increasing the confidence of other creditors. Society also benefits participation and support from creditors who have become associated persons/shareholders. The latter will be directly interested in the success of the company and can contribute their own knowledge and resources to support the development of the business.

From the point of view of the investor (creditor), there may be many reasons for using the debt-to-equity mechanism: firstly, if the profit from dividends is more stable than the profit obtained as a result of the return of loan capital and the corresponding interests. Second, the financier may be interested in controlling the company. In this regard, we will talk about a strategic investor: the lender will himself benefit from the products/services developed by the startup. For example, an oil company is interested in financing and controlling an IT start-up that has proposed to develop software to determine oil reserves.

CONCLUSIONS

Mechanism of conversion of debt obligations into equity sharesrepresents an alternative method of financing, attractive for startups, respectively for “business angel” investorsor venture capital investors. The investor will “overcome” his status as a simple creditor – he will become an associate / shareholder of the company, and the return of the financing will be made in the form of dividends distributed from the profits received by the company. Thus, the financier will have a direct and concrete interest in the development and promotion of the entrepreneurial project, also having the contribution of know-how, commercial relations, business experience, etc., with which he will help the company to develop and generate profits. In this context, the transformation of debt into social capital stands out as a way by which a company’s debts can be transformed into real opportunities for its development.

Article signed by Av. Alexandru-Laurentiu Mihai, junior lawyer – [email protected] – STOICA & Asociatii.