Issuing convertible bonds and loans for SMEs

Last updated on January 9, 2024

In our previous article on issuing shares in a private company, we wrote about how the owner of a Small and Medium Enterprise (SME) seeking to expand can raise capital through issuing debt in the form of bonds or equity in the form of shares. However, did you know that there is a middle path of convertible loans or convertible bonds? Such instruments combine aspects of both debt and equity fundraising. As issuers have flexibility in setting the exact terms of such instruments, this can potentially allow SME owners to attain the best of both worlds when attracting capital by retaining control over the management of the business while moderating debt liability.

What are convertible loans and bonds?

In a convertible loan, one party lends money to a company but instead of simply receiving their capital with interest on the repayment date, they typically accept lower interest payments in exchange for the right to receive repayment in the form of shares in the company.

Sometimes, these take the form of convertible bonds. Imagine Company A issues a 5-year bond paying a 5% annual coupon rate and Mr B is issued a $1000 bond on the initial issuance date of 1 April 2023. In a bond, a sum of money is loaned to the company but this is securitised and can thus be bought and sold by lenders. This is unlike a normal loan where a lender must typically wait until the contractual due date for monies owed before being able to recoup their capital, unless they sell their right to collect the debt through the process of assignment, which is not always contractually permissible.

Bonds are similar to loans in that the borrower pays a coupon rate (interest payments) to whoever owns the bond at the relevant date. Interest payments are typically made annually from the date of issuance. In our example, Mr B is entitled to a $50 coupon payment annually, assuming he is still the holder of the bond. Upon maturity, the company will be obliged to redeem (i.e. pay back) the bond in full. For Mr B, this would be in 31 March 2028.

For a convertible bond or loan, however, Mr B may opt to convert his $1000 bond or loan into 1000 ordinary shares in Company A with a nominal value of $1 each. These numbers and ratios can of course vary according to business needs.

Can I provide a convertible loan?

If you are looking to invest in a company through a convertible loan or bond, you should be conscious of the rules laid down in the Moneylenders Act.

It is illegal to carry on the business of moneylending without a licence, unless one obtains an exemption from licensing from the Monetary Authority of Singapore (MAS), or one is an excluded moneylender. Section 3 of the Act states that anyone who lends a sum of money in consideration of a larger sum being repaid (this typically refers to the provision of a loan (which can include a bond) in consideration for repayment with interest) “shall be presumed” to be a moneylender but this presumption is rebuttable by contrary evidence.

Anyone who operates as a moneylender contrary to the Act will be barred from enforcing their repayment rights through the courts. However, if you only lend to corporations, or if your business does not have the primary objective of lending money, then you may be deemed an excluded moneylender and would thus not need to be concerned with the Act. When entering into a convertible loan agreement, the agreement should thus clearly state that the loan is made to the company (and perhaps personally guaranteed by the owner of the business) rather than lent to the company and the owner jointly.

Can I issue a convertible loan?

Additionally, issuing securities is subject to the Securities and Futures Act. In a convertible loan or bond, securities in the form of bonds or shares will be issued. For the purposes of SMEs, what is most important to note is that multiple restrictions apply to the offering of securities to the public. Typically, only big companies planning to list on the SGX-ST or other stock exchanges will offer their securities for public subscription. However, a limited offering of bonds or shares in a private company to limited subscribers would generally be exempt from these rules.

How do I issue a convertible loan?

In principle, a loan would not require more than a simple IOU. However, as a convertible loan is more complex, it is important to obtain legal advice when drafting such an agreement. For instance, shareholder approval as required under the Companies Act needs to be obtained for the issuance of new shares for the loan or bond conversion.

From the outset, the lender would typically request certain covenants to feel more secure in making the loan. A covenant is essentially an enforceable promise and could include, for example, a covenant not to remove certain key assets from the company or to not further increase business debts beyond a certain level. Beyond this, borrowers and their lawyers should specify the purpose of the loan, consider arranging the loans and the repayment dates into different tranches to manage cash flow obligations, and decide the terms of repayment or even prepayment if the borrower wishes to pay off the loan early.

Converting from loan to shares

Crucially, the rate of conversion from loan to shares will need to be specified beforehand (e.g. 1:1 as in our example above). Additionally, the window to exercise this option should be specified, such as by requiring the bond-holder to notify the company of their wish to convert their bond to shares one month prior to the maturity date of the bond or the repayment date for the loan.

It should be clear who has the right to decide on the conversion. The decision to convert could be made by the bondholder or lender, by the company, or even by either party. In all cases, it is likely that the decision to convert ought to be kept within strict limits such as the window for conversion or only allowing conversion upon certain triggering events such as the completion of the company’s next round of equity fundraising. Such restrictions facilitate commercial certainty and predictability.

On the part of the borrower, the borrower should ensure that there is no impediment to issuing shares to the lender in the eventuality that the loan is converted. A prior Shareholder Agreement entered into between the existing shareholders of the company, or the constitution of the company, may contain pre-emptive rights requiring new issuances of shares to be offered to existing shareholders first.

Should I issue a convertible loan?

As a business decision, SME owners should decide if the advantages of lower interest payments and the cash-flow benefits of not having to repay the capital sum outright at the end of the term make up for having to issue shares to the lender, and thus diluting their own control of the company. Particularly, as a loan-to-share conversion rate must be specified beforehand, if your company experiences significant growth from the time of borrowing to the time of repayment, the fair market value of the shares to be issued may significantly exceed the loan quantum. The conversion ratio may have to be adjustable and pegged onto the net asset value of the company or certain other agreed metrics.

Ultimately, if you think that issuing convertible loans may benefit your business, it would be best to discuss your exact requirements with a lawyer. In terms of structuring this sort of transaction, precision is key to maximise value for both you and your investors. SingaporeLegalAdvice.com provides a directory of corporate lawyers whom you may want to consider.