Debt or Equity?

We regularly see companies raise very large sums, sometimes £100m+, under convertible loan notes with a clear intention that the funding is treated as equity, not debt, for balance-sheet and disclosure purposes.

In some sectors, that distinction really matters. A clean balance sheet, no debt, and visible long-term investor support can be critical to credibility with customers, regulators and commercial partners, particularly where a company is competing with a well-established incumbent and still proving its long-term viability as a newer market entrant.

Everyone involved understands that CLNs can be debt, but many are deliberately structured to support equity classification, and that classification can turn on relatively narrow features in the drafting. In many cases, the starting position may be, for example, that the CLN:

• is not redeemable at maturity;
• converts at a fixed price (for example, a discount to the next round) into a fixed number of shares; and
• delivers investor protection through liquidation preference, rather than repayment.

On its face, that looks and feels equity-like. But where we have seen issues arise is during audit under a more stringent application of IFRS / IAS 32. In particular, features that introduce a contractual obligation to deliver cash on a change of control have been scrutinised more closely. Even where those outcomes are economically intended to mirror equity upside, this can be decisive for classification. This can be the case even if:

• cash settlement would only ever arise in contingent circumstances;
• the company expects those payments to be funded from transaction proceeds on the change of control; and
• the economics were intended to replicate an equity-style return.

From an accounting perspective, the mere existence of an obligation to repay cash, even funded by a buyer on a change of control, can be enough to tip the instrument into debt treatment, meaning a significant liability appears on the balance sheet, solvency and distribution analyses change, future equity or debt financing becomes more complex and later-stage investors, customers and counterparties may take a different view of the business

The takeaway

We have seen multiple companies amending CLN terms to address the debt-versus-equity assessment following audit cycles, rather than to change the commercial deal.  The economics stay the same but the balance-sheet treatment does not. If balance-sheet presentation, credibility and future financing matter, the debt-equity analysis needs to be built into the structure from day one.