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Convertible Debt as an Alternative to Equity Financing

From aspiring business empire builders to those with ideas that could revolutionise an industry, funding growth can be a sticking point. Commonly, many ask friends and family; others acquire debt from institutions that have rights at liquidation before the owners; some may opt for offering ownership of a portion of their company to fund this growth, otherwise known as equity financing. Recently Thai law has recognised that a hybrid method of financing, very regularly used in more liberalised markets like Singapore, is required to increase the flow of investment into SMEs and listed companies alike, ready for explosive growth.

Convertible debt financing is one such method.

What is Convertible Debt?

Convertible debt (also known as convertible notes) is a loan provided by an investor that can be converted to equity, either at a specific date or once contractual milestones have been reached. Like other forms of debts, the loan note has interest and a maturity date. The difference being that should the investee offer equity for subsequent funding (known as a Qualified Financing round when investment exceeds a certain threshold) before the maturity date, the convertible noteholder can convert the loan into equity shares in the investee, normally at a discounted rate.

An example would be that Company A has landed a very large contract and requires THB 10 million funding for expansion and manpower to meet the terms of the contract. Investor B agrees to fund this through a THB 10 million convertible loan at 8% annual interest over 24 months. The convertible loan contract stipulates that in this situation, Investor B can receive shares at a 20% discount of the share value offered in a qualified funding round. Company A enters Series A equity funding, a qualified funding round, 18 months following the convertible notes issue. Investor B now has the right to convert the principal plus accrued interest (THB 10m plus THB 1.2m interest) into shares at a 20% discount to the share value offered at the equity funding round. This is known as “uncapped convertible note”.

Capped convertible notes recognise that early investors are taking large risks investing in companies going through strong growth or early in the business’ life, especially when taking into consideration that funding from the convertible loans can be used to create a much more valuable company when share prices are determined. This means that the share value for loan noteholder s (i.e., the conversion price of a loan note) will be based on the company’s valuation cap stated in the convertible loan agreement rather than the company value at a qualified funding round. A valuation cap on the note ensures the loan noteholder receives potentially a larger portion of equity at qualified funding rounds as compensation for investing early in the business compared to those investing at qualified funding rounds.

Following from the example above, say Company A issues convertible notes stipulating a valuation cap at THB 100 million. The THB 10 million convertible debt financing has allowed them to raise the value of the company to THB 200 million at the Series A equity funding round. This effectively means the convertible noteholder gets double the number of shares for the same price as investors in the Series A funding round to due to the valuation cap.

It is possible that the convertible note issuers do not meet the milestones to trigger conversion or go into qualified funding rounds. Investors and convertible noteholders at this point can continue the loan to term until redemption and collect interest on the principal as per normal loan agreements.

Convertible loan notes in Thailand

Convertible loans have been available for public companies for many years. Since 2020, private SMEs have been able to get involved in convertible debentures through private placement by pre-selected investors, meaning the offer for convertible loans cannot marketed to the public – a regulation stated by the Securities and Exchange Commission, Thailand (SEC).

To qualify, SMEs must fit into the following criteria:

Type of Enterprise Small Enterprise Medium Enterprise
No. of Employees Annual Income (in millions THB) No. of Employees Annual Income (in millions THB)
Production < 50 < 100 51 – 200 100 < x < 500
Trade and Services < 30 < 50 31 – 100 50 < x < 300

 

A further consideration is the type of investors approved by the SEC that are allowed to invest in SMEs via convertible notes, the size of the investment and the number of investors:

Type of Investors Limit of Investment (THB) No. of Investors
Small Enterprise

Institutional Investors, Private Equity, Venture Capital, Angel Investors, Employees or Directors of SMEs

No Limit No limit
Medium Enterprise

Institutional Investors, Private Equity, Venture Capital, Angel Investors, Employees or Directors of SMEs

< 20 million < 10 investors

 

It is worth noting the SEC will refresh its definitions (via Notification No. Kor Jor 39/2564) of institutional, high net worth and ultra-high net worth investors, effective 1 October 2022.

SMEs are also required to register for the Capital Market Fundraising Promotion Project for SME (PP-SME) with the Office of Small and Medium Enterprises’ Promotions (OMSEP). A company factsheet should also be prepared for submission to the SEC within 15 days of offer close.

Benefits of Convertible Loan Financing

   Convertible loans are typically simpler and faster to arrange from a legal standpoint, thus less expensive than equity financing.

   Convertible notes allow the company to delay putting a value on itself, especially in the early stages of the business. Early-stage valuation of the company is, at best, an approximation and may not be representative of the value that will be brought about because of the funding. Furthermore, it could inadvertently create an anchor point for future valuations of the company, potentially lowering the size of the investment.

   It provides a bridge between larger rounds of equity, without disclosing sensitive information.

   Investors can make cash regardless of whether the company goes into qualified funding rounds from interest payments, as well as acquiring a larger share of equity due to accrued interest compared to if the investor waited until equity shares were available to purchase.

Risks to be considered

   Multiple scenarios need to be considered for both the investor and the investee depending on the range of likely outcomes, including exit points for investors, who should also take into consideration of the inherent risk of investing in early-stage businesses.

   The relatively short period of time for an organisation to reach milestones stated in the convertible loan contract before maturity may not be feasible.

   Depending on the aims of the organisation, a portion of the company will be held by investors at or before maturity. The presence of a valuation cap and automatic conversion price could further affect the distribution of equity amongst owners.

   Although the valuation of the share price is delayed through convertible debt, an anchor may be set around the valuation cap, which could affect negotiations around future valuations.

The variability of convertible loan contracts

A surface review of convertible debt financing makes it look very appealing for both the investor and the investee. Before an organisation decides to go down this route, there are numerous factors to consider. The variability of contracts in terms of voting rights, maturity dates, redemption options, discounts, valuation caps, both discounts and caps, neither discount nor valuation caps etc. need to be balanced with the strategy of the company and the risk appetite of both investors and company directors. Thai laws and SEC regulations add another level of complexity that needs to be understood with experts in the field, allowing you to make a well-informed decision as to whether this is the right approach, company structure or using alternative financing routes altogether.

 

MPG has over two decades of international corporate financing experience that have supported numerous companies through funding rounds and IPOs in Thailand. To discuss your options of investing or raising funds please address your request to our Banking & Finance Department at info@mahanakornpartners.com.

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