Convertible Notes: Simplicity v. Ambiguity

In a recent post, I wrote about how convertible loan notes can sit uncomfortably between debt and equity, and how narrow drafting can have balance-sheet consequences. For this reason, as I discussed, convertibles will often convert into equity on change of control rather than be repaid.

This gives rise to another issue that we see arise later in the lifecycle, around conversion mechanics on an exit.

Convertible instruments are, in many respects, designed for speed and simplicity. That simplicity, however, can lead to ambiguity.

“Conversion at the exit price”

A common formulation is conversion on an exit at the exit price (often subject to a discount). In practice, that is rarely straightforward.

In M&A, there is seldom a single, clean, up-front price. Consideration is usually made up of a mix of elements:

• earn-outs and deferred payments
• escrow or retention amounts
• working-capital adjustments
• W&I deductibles
• non-cash consideration

The economic value ultimately received by sellers often differs materially from the headline number. As such, a clause that says a note converts at “the price paid per senior share” raises an obvious question: which price?

Why this is often parked

In many cases, this issue is consciously deferred. No one is thanked for slowing down a bridge financing or convertible round by over-lawyering hypothetical exit mechanics. Often, that is a sensible commercial compromise. Where it is addressed, it is usually done by anchoring conversion more precisely, for example:

• expressly linking conversion to a pre-agreed equity value, rather than the exit price; or
• confirming up-front whether non-cash or contingent consideration (such as an earn out) is included and whether escrow or W&I deductions are taken into account.

Each of those choices affects the implied valuation and, in turn, the number of shares issued on conversion. For example,  if the earn out is included, the price will be higher, and the investor will receive fewer shares, even though the earn out may never be paid. There is no easy answer to this and so often linking conversion to a pre-agreed equity value is preferable.

A practical drafting tool

In addition to agreeing the principles up front, one of the most effective ways to surface misaligned assumptions is to include a worked example in the document itself, which forces everyone to confront the maths. Above all, vague phrases such as “exit price” or “total consideration” are best avoided, in the context of an M&A exit.