Bridge Financing Round: The Use of Convertible Notes

Bridge Financing Round: The Use of Convertible Notes for Fundraising in Malaysia

The Covid-19 pandemic has caused an adverse impact on the global economy in 2020 which will likely carry into a good part of 2021. Understandably, investors are more conservative with their cash and even institutional investors and venture capital firms have been more selective in picking their portfolio companies. Consequently, start-ups will find it more challenging to raise capital in this turbulent time.

Typically, a company that intends to raise capital via an issuance of equity is looking to raise a specific amount of money for a particular purpose, commonly starting with seed round and then proceed to Series A, Series B, etc. In the current economic climate, where a company needs to raise capital quickly but is not able to justify the targeted valuation or investment amount, either due to tepid investor appetite or if the company cannot hit its commercial milestones, convertible notes can be a useful fundraising tool as a ‘bridge’ between the series financing rounds, allowing the company to still raise funds and receive its vital cash injection, but only to issue actual shares later on, based on a valuation determined only at a subsequent equity financing round.

In this article, we explore the common features of convertible notes and the regulatory framework on the use of convertible notes in Malaysia.

Can Malaysian private unlisted companies issue convertible notes?

Under Securities Commission Malaysia’s (“SC”) Guidelines on Unlisted Capital Market Products under the Lodge and Launch Framework (revised as at 12 November 2020), convertible notes issued or offered to registered Venture Capital and Private Equity Corporations and Management Corporations are exempted from specific requirements that apply to convertible corporate bonds, provided that all the following criteria are met (“Eligible CNs”):

• The issuance and offering must be solely to a person or persons registered with the SC under the Guidelines on the Registration of Venture Capital and Private Equity Corporations and Management Corporations;

• The convertible notes must not be transferable, save and except to persons registered with the SC under the Guidelines on the Registration of Venture Capital and Private Equity Corporations and Management Corporations;

• The convertible notes may only be convertible into shares of the issuer; and

• The tenure of such convertible notes must not exceed seven years from the date of issuance.

However, there are some regulatory compliance steps involved in issuing such Eligible CNs. The company which issues Eligible CNs must still lodge all necessary information and documents to the SC prior to the issuance and observe critical timelines and notification obligations prescribed by the SC thereafter. Proper legal advice should be sought to avoid falling foul of these securities laws.

Commonly Negotiated Features of Convertible Notes

Generally, a convertible note is a hybrid instrument constituting a short-term debt that can be converted into equity, usually upon the next financing round of the company.

In the context of start-up financing, most VC investors that enter into a convertible note usually do not expect the money to be repaid (even though they technically can call for repayment), but rather having the debt converted into equity upon reaching certain milestones, and hence becoming a shareholder in the near future.

Some common and negotiable features of convertible notes are:

1. Valuation Cap. A valuation cap will be agreed on. By having a pre-agreed valuation cap, the investor “locks in” his conversion rate at the valuation cap and benefits from receiving more shares if the company is valued at a higher amount in the subsequent equity round. To illustrate, if the valuation cap at the bridging round is RM5mil but the company is valued at RM10mil at the subsequent equity financing round, the note amount will be converted into equity as if the company is valued at only RM5mil. This provides the investor at the convertible note round an upside and advantage over the investor at the financing round, as such the investor will get twice as many shares as the financing round investor for the same amount of investment. If the valuation cap is set too low, it could result in significant dilution for the founders if the subsequent equity round far exceeds the valuation cap.
2. Discount. A discount on the subsequent round’s subscription price may also be provided to the investor. In addition to a valuation cap, the company may provide a discount to the investor, for taking the risk of injecting capital prior to the actual financing round. Providing a discount means the investor gets to convert the note amount to equity at a pre-agreed discount of the subscription price paid by the later investors, regardless of the company’s valuation at the next equity round (hence, different from the valuation cap mentioned above).
3. Maturity Date. The maturity date refers to the date at which the note must be repaid for or converted into equity, even if a subsequent financing round does not take place by then.
4. Interest. A convertible note, having features of a debt, usually also provides for an interest rate or coupon rate which will be added onto the principal note amount. In the event the convertible note is not converted but repaid instead, the principal and accrued interest will be payable to the investor. Founders are cautioned against agreeing to a high or cumulative interest rate, as the interest amount will contribute towards more dilution upon conversion, especially if the subsequent equity round only happens much later than expected. Typically, the investor’s right to demand for payment arises at Maturity Date, or when an event of default occurs (for example when the company is being wound up).

The above are just some common negotiable commercial terms in convertible notes. As the devil’s in the details, there are still a number of other legal and commercial terms within a convertible note that can and should also be negotiated carefully with a sophisticated investor.

While convertible notes appear to provide a lot of upside to the investors, it could also serve as an ideal alternative financing instrument to the start-up prior to or in between a formal equity series round, as it is relatively less complicated, has fewer variables to negotiate than a round of preference shares, and hence enabling the bridging round to close faster. It also defers the prickly issue of share valuation and pushes the entry of note holders as shareholders to the next round.

Regardless, it is always important for the founders and investors to enter into the transaction with both eyes wide open, which means fully understanding the impact of the commercial terms, especially what impact it brings in the subsequent equity round, and not just signing off on the instrument hastily.

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This article was written by Shawn Ho and Ee Lyne Chong.  Shawn leads the corporate practice group of Donovan & Ho, and has been recognised as a Notable Practitioner, whilst the firm has been recognised as a Notable Firm for Corporate and M&A by Asialaw Profiles 2020 and 2021.  We are also ranked as a Recommended Firm by IFLR1000 2020 and 2021.

Our corporate practice group advises on corporate acquisitions, restructuring exercises, joint venture arrangements, shareholder agreements, employee share options and franchise businesses, Malaysia start-up founders and can assist with venture capital funds in Seed, Series A & B funding rounds.  Feel free to contact us if you have any queries.